Risks of Investing in IPOs: A Complete Investor’s Guide

Opening a new business venture involves uncertainty – despite careful planning, its success depends on various factors beyond the owner’s control. Similarly, investment in IPO opportunities carries inherent risks about which investors should know.

In India’s rapidly growing IPO market, which saw record volumes in 2024, understanding what an IPO is and the associated risks is crucial for making informed investment decisions. Gaining a clear understanding of the full spectrum of risks involved in IPOs will empower you to make more careful and strategic decisions.

What is an IPO?

An Initial Public Offering (IPO) is the process by which a privately held company offers its shares to the public for the first time, and gets listed on a stock exchange. Through this process, companies seek to raise capital from public investors to fund expansion, pay down debt, or invest in new projects. Understanding what an IPO in the stock market helps investors recognise the fundamental aspects of IPO investing. The IPO process involves various stakeholders, including the issuing company, underwriters (who facilitate the offering), regulatory bodies, and investors. Each IPO sets a specific IPO risk percentage that investors should evaluate before participating.

Risks Investors Should Be Aware of

1. Over-Valuation Issues 

Market hype can lead to overvaluation during an IPO, especially if the company’s fundamentals are not strong enough to justify the initial pricing or IPO price band. This presents a significant IPO risk for investors, as they may face challenges when the stock underperforms after the public listing. For instance, several high-profile IPOs in 2021-22 have seen their stock prices decline post-listing, highlighting the risks of pre-IPO investing.

2. No Assurance of Share Allotment

When applying for shares in an IPO, the allocation of shares remains uncertain. Recent data from Indian IPOs shows many issues being oversubscribed several times over, sometimes exceeding 100 times subscriptions. Such high demand reduces individual investors’ chances of receiving shares, adding another layer of uncertainty to IPO stocks investments.

3. Insufficient Information About the Company

Companies entering the public market often have limited operational history. This lack of track record may increase the risk as investors have fewer data points for analysis and investors are left with limited insight into the company’s long-term viability. Unlike established public companies, new entrants may not provide extensive historical performance data, making it challenging to assess their long-term potential.

How to Mitigate IPO Risks

1. Thoroughly Review the Prospectus

The prospectus contains critical information about and the company’s fundamentals. This document outlines business models, financial statements, and risk factors. In India, SEBI mandates comprehensive disclosure requirements, ensuring transparency and enabling investors to better understand what an IPO in the stock market entails.

2. Avoid Market Hype

Market enthusiasm around IPOs can create unrealistic expectations. For example, an IPO risk  often increases when media coverage and market speculation drive up pre-listing interest without fundamental support. Investment in IPO decisions should focus on company fundamentals rather than market excitement.

3. Assess Your Financial Goals

Before investing in an IPO, understand your investment objectives and risk tolerance. Recent market data shows that IPO performance varies significantly across sectors and market conditions. Understanding personal risk tolerance helps in making appropriate investment decisions.

4. Risks of Investing with Leverage

Using leverage or borrowed funds for IPO investments can increase your risks. Several cases in the Indian market demonstrate how leveraged positions in IPOs led to significant financial stress when listings didn’t perform as expected.

5. Evaluate the Company’s Financial Health

Financial analysis provides crucial insights when considering whether to invest in an IPO or not. Examining revenue growth, profit margins, and debt levels helps assess company stability. This evaluation becomes extremely important for newly listed companies with limited trading history.

6. Assess Competition

Understanding the competitive landscape helps in evaluating an IPO in a better way. As an investor it is best recommended to run a quick research on the IPOs of the peers and see how they performed in their initial public offering.

7. Reputation of Underwriters 

The credibility of investment bankers managing the IPO may also be considered. Established underwriters often bring better-prepared companies to market, potentially reducing overall IPO risk for investors.

Conclusion

The IPO market presents opportunities but requires careful consideration of various risks in IPO investment. Understanding what an IPO in the stock market entails, and recognising the potential pitfalls such as overvaluation, limited company history, and share allocation uncertainties, is essential for investors. By thoroughly reviewing the prospectus, avoiding market hype, aligning investments with personal financial goals, and evaluating the company’s financial health and competitive positioning, investors can mitigate risks.