Like real estate flippers, initial public offering (IPO) flippers are investors who want to buy low, sell high and exit with a quick profit. And who can blame them? IPO stocks are notoriously volatile. They often shoot up in the excitement of the first day of trading but can decline steeply afterward as the untested stock finds its footing. How does flipping affect an IPO’s success, and how do companies that go public feel about flippers? Let’s find out.

How Does an IPO Work?

To understand IPO flipping, we must first discuss the basic mechanics of the IPO process. The company that wants to go public—meaning that it wants to sell stock, or equity, to outside investors for the first time—hires several investment banks that work together in an underwriting syndicate to market the stock to institutional investors at the initial public offering price. The underwriters must first buy the shares from the company, then sell them to investors in order to earn an underwriting fee. These initial sales are very large, which is why they require multiple underwriters and why they target institutional investors with deep pockets. On the day the company goes public, those institutional investors can either hold or sell all or some of their shares. If they sell, it is considered flipping, since they held the stock for such a short time.

Why Flip?

So an IPO flipper is someone who buys an allotment of shares in the primary market of a company going public and then sells those shares right away in the secondary market instead of holding onto them. The temptation to sell shares is strong, since the opening price is often significantly higher than the IPO price, creating the possibility for a quick and easy profit. Twitter, Inc. (TWTR) and LinkedIn Corp. (LNKD) are two recent examples of companies that experienced an IPO pop. Anyone who flipped shares of Shake Shack, Inc. (SHAK) or Etsy, Inc. (ETSY) earlier this year also stood to make a tidy profit, as each stock's price about doubled the first day. (Learn more in The Road To Creating An IPO.

Sometimes stocks that pop on day one retain their value, and other times they plummet. Flippers aren’t interested in holding onto newly issued stock long enough to find out. Wanting to make a quick and easy profit isn’t the only reason to flip, however. To understand why, keep in mind that most IPO shares go to institutional investors, who manage their investments differently than retail investors.

“Institutions will often flip if they do not receive a large enough allocation to assign an analyst or manager to follow the holding,” says Raymond P. H. Fishe, distinguished professor of finance at the University of Richmond’s Robins School of Business in Virginia. For example, an institutional investor may feel that it needs 50,000 shares to justify monitoring the stock. If the institution is allocated 40,000 shares, it will probably buy 10,000 more in the aftermarket to meet that threshold. However, if it is allocated only 10,000 shares, it will probably sell them, says Fishe.

Flipping might seem like it would have originated during the excitement of the dotcom bubble, but “it has always been a concern because of the average underpricing of IPOs,” Fishe says. We just heard more about the problem during that time because “the dotcom underpricing was quite substantial, so there was a much greater incentive to flip.” (Learn more about bubbles in Economic Bubble: Toil and Trouble!)

Do Companies Hate Flippers?

Underwriters want to control who flips stock in an IPO and how many shares get flipped, Fishe says. They need to have “a reasonable estimate of how much of the allocation is expected to trade once the stock opens,” he says. For the most part, companies that are going public want underwriters to find buyers who want to hold the stock and possibly increase their holdings later if the company does well. Flippers don’t fit this description and are thought of as sellers, not buyers. However, companies need some of their shares allocated to flippers to facilitate trading on the first day. (For related reading, see 5 Tips For Investing In IPOs.)

“No flippers means no trading, which would be a disaster,” Fishe says. “So the problem they face is to control the amount of flipping.”

Flipping generates trading activity. Without flippers, there would be no stock for retail investors and the general public to buy on the secondary market. But underwriters must determine the mix of buyers and the offer price that will lead to strong after-market performance for the newly issued stock. If there are too many shares flipped, the extra supply could flood the market and lower the stock's price. If the IPO is weak, meaning that the stock’s after-market price falls below the offering price, underwriters may have to purchase back flipped shares to shore up the price. This price support is not only good for the newly public corporation but also for the underwriters and the IPO subscribers who didn’t flip their shares. (Learn more about how underwriting works in Underwriting Corporate Securities.)

Discouraging IPO Flippers

With the exception of the lock-up period that prevents company insiders from selling newly issued stock for several months after the IPO, there is no government regulation prohibiting flipping IPO shares. However, the market imposes formal and informal checks on IPO flippers.

One check against rampant IPO flipping is that the Depository Trust & Clearing Corporation (DTCC) tells underwriters when their clients sell shares in the first few weeks after the IPO. Underwriters want to make sure that clients who say they aren’t going to flip follow through on their promise, since underwriters set the offering price based in part on trading expectations. Remember, underwriters may also be on the hook to buy up flipped shares if prices drop too much. If an underwriter learns through the DTCC that a client broke a promise not to flip, the underwriter may not offer the client shares of the next IPO it sells. Clients that plan to flip their shares will usually let the underwriter know because they don’t want to jeopardize future business opportunities.

The second form of market regulation comes in the form of brokerage guidelines to customers. The brokerage may limit which of its customers can participate in an IPO by requiring that the customer hold a minimum amount of assets (such as $500,000), and that they’ve surpassed a certain number of trades in the last year (the threshold is 36 at Fidelity, for example). In other words, the brokerage’s biggest customers get preferential treatment when it comes to buying IPO shares.

Brokerage firms also are required by law make sure that only sophisticated clients who understand and can manage the high risks of participating in an IPO purchase shares, and clients with low balances aren’t likely to fall into this category. In addition, brokerage firms typically don’t receive large IPO allotments to sell to retail investors; underwriters allot most shares to institutional and wealthy investors who are capable of buying in large quantities, assuming high risks and holding the shares long term. With a limited quantity of shares, brokerage firms have to be picky about whom they offer them to.

If a customer qualifies and is lucky enough to acquire shares, the brokerage may let the client know that while he or she is free to sell those shares at any time, doing so within the first two to four weeks after the shares begin trading in the secondary market will be considered flipping and will make the client ineligible to participate in future IPOs for several months to a year. Repeated offenses can result in penalties as severe as a lifetime ban on IPO participation with that brokerage. Would-be flippers should understand how the brokerage they trade IPO shares through defines flipping and what the consequences will be if they decide to flip.

The Bottom Line

IPO flipping isn’t all bad. In fact, flippers are essential to an initial public offering’s success in that they quickly make shares available in the secondary market. It wouldn’t look good if a newly public company saw no trading activity in its stock. The key is to control the amount of trading by trying to determine ahead of time which investors seeking IPO allotments want to buy and hold and which want to flip. (For more in-depth information about how initial public offerings work, read our tutorial IPO Basics: Don’t Just Jump In.)