What Is a Hot IPO?

A hot IPO is an initial public offering of equity in a company that appeals to many investors and for which there is an elevated demand for its stock.

There are other ways to go public other than an IPO, including a direct listing or direct public offering. When a company starts the IPO process, a specific set of events take place facilitated by chosen bank underwriters.

Key Takeaways

  • An IPO is an initial public offering of equity in a company; a hot IPO is one that garners great interest and investor demand.
  • A private company looking to go public will bring in one or more banks to underwrite the issuance and handle the pricing, marketing, and decisions about the number of shares and share price range.
  • With a hot IPO, the demand for shares surpasses the initial supply of shares, and the price range needs to be revised upward.
  • If a hot IPO is underpriced, it will likely see its stock price rise after the shares begin trading; if it is overpriced, the stock price will likely drop.

Understanding a Hot IPO

Companies that opt to issue stock via an IPO can raise a substantial amount of money in a short time, particularly if the issuance attracts public attention and becomes a hot IPO. An initial public offering gives a private company a chance to cash in on the public’s demand for its shares.

When a company decides to make such an offering, it typically finds one or more investment banks to underwrite the issuance and make arrangements to sell shares on public stock exchanges. The underwriters market the IPO as they help the company set a per-share price. The underwriting banks will assume a specific number of shares, which they will offer to their buyers, and collect a portion of the sale proceeds as a fee. These buyers may be institutional or retail clients. The part they receive is the underwriting spread.

Oversubscribed Hot IPO

Hot IPOs appeal to investors who anticipate that the demand for shares will outstrip the number of shares offered. IPOs with more demand than supply are considered oversubscribed, making them a target for short-term speculators as well as those who see a long-term opportunity in holding the equity.

Also, increased demand for the shares will lead to a sharp rise in the price of the stock soon after it begins trading. Usually, this sudden increase in share price is not sustainable.

Because a hot IPO is likely to be oversubscribed, companies will often permit their underwriters to increase the size of the offering to accommodate more investors and make more money. The trick for underwriters lies in balancing the size of the IPO with the appropriate price for the amount of interest in the shares. When done correctly, this balancing will maximize profit for the company and its underwriter banks.

If a hot IPO is an underpriced issue, it will usually see a rapid rise in price after the shares hit the market and the market adjusts to the high demand for the stock. Conversely, overpricing the IPO can lead to a rapid fall in prices, even though the higher price benefits the underwriting bank issuing the stock since it only makes money on the initial issue.

Initial shareholders are significantly affected by sharp moves in price after trading opens to the general public. Underwriters sometimes give preferential treatment to high-value clients when offering shares in a hot IPO, so they bear some risk if they overprice the stock. However, a hot IPO does not provide a guaranteed win for investors. Sometimes the hype of an upcoming IPO does not bear the planned fruit for the investor.

Facebook IPO as a Cautionary Tale

Such was the case when social giant Facebook announced its plans to go public. In early 2012, analysts indicated that the long-awaited Facebook IPO, seeking to raise about $10.6 billion by selling more than 337 million shares at $28 to $35 per share, could generate such significant interest from investors. These analysts predicted an oversubscribed IPO.

At the market opening on May 18, 2012, as predicted, investor interest showed there was more demand for Facebook shares than the company was offering. To take advantage of the oversubscribed IPO and fulfill investor demand, Facebook increased the number of shares to 421 million but also raised the price range to $34 to $38 per share.

In effect, Facebook and its underwriters raised both the supply and price of shares to meet demand and diminish the securities oversubscription. However, it quickly became clear that Facebook was not oversubscribed at its IPO price, as the stock fell precipitously in its first four months of trading. The stock failed to trade above its IPO price until July 31, 2013.