As a retail investor, never, ever buy a tech stock during its IPO.

Stock markets have not been kind to tech companies that have recently gone public. Additionally, we have seen lesser and lesser IPOs from tech companies in the past 18 months. This is simply a reflection of the Grand Canyon-like gap between the valuations “unicorns” have enjoyed while they were raising private money and the value public markets investors are willing to pay for companies whose business models, competitive position and cash burn all point to a “pony with a plastic horn” anatomy.

That being said, we will see, at some point in time, more tech IPOs. And when that happens, as retail investors, you should stay away from these stocks as if they had an Ebola strain attached to each share until these companies settle down as going concerns and publicly traded stocks. Here is why.

What I am about to expose is nothing new. As a matter of fact, it has been a common practice for years. There is nothing illegal about these practices. They are designed to benefit a select few (always the same). Because of these practices (or schemes), a retail investor buying a stock at or near its IPO is sure to regret it.

Let us start with a privately held tech company who is about to go public. Most of its capital came from VCs (Venture Capital firms) who invested over several rounds to bring the company up to scale. The founders are also shareholders. The executive team and some of the employees have options (options to buy share at a discount). All these constituents have a legitimate desire to, at some point in time, monetize their investments, their innovation or their contribution to the company’s growth. So far so good.

What is the primary purpose of an IPO? First and foremost, it is to raise more capital to fuel more growth. And second, to provide a regulated trading market for the shares of the company.

Now a few technical points. When the shares of the company begin trading, the existing shareholders may be able to sell some of their existing holdings in the IPO. However, most of the existing shares will be locked up for a specific period of time (say 6 months). What does that mean? It simply means that for a period of 6 months (in my example), the actual number of shares trading is going to be artificially lower than the total number of outstanding shares. When the lock up period expires, a new (huge) pool of shares comes on the market, primarily from insiders who want to capitalize on the fact that there is a market for those shares. That is a perfect set up for short traders simply because a sudden oversupply of shares coming all out once on the market is likely to create a downward price pressure on the stock. (For those interested in this kind of things, see how the % of shares shorted has a tendency to increase around the end of lock up periods)

Lesson#1. Do not buy a tech stock until ALL the locked up shares have been released and digested by the market.

But let us go back to the IPO itself. The process is driven by investment bankers who rack up very substantial fees on the proceeds of the IPO (the sale of new shares of the company). Say that the company sells for $100M of new shares, and the brokerage fee is 6%, then the underwriters will get a $6M check. And in many cases, they also get warrants to buy shares of the company in the future at a specific discount.

Lesson#2. You need to understand the terms of the underwriting agreement between the banks and the company. How much money do they get for taking the company public and what are the warrants they have secured (how many, what discount do they get, when can they exercise them).

Now, I am sure you have noticed that most tech IPOs “pop” on the days following the first day of trading, sometimes by 25% or even 50%. How can that be? Because if the IPO is “priced” correctly, ie reflects the intrinsic value of the stock, it can’t be that its value appreciate that much in so little time. The mechanism is extremely simple. First, you create a huge demand for the stock (mainly via hype). Second, you put on the market a relatively small amount of new shares (the float) available for sale [understand that in some IPOs, the float (new shares) is only 15% of all the outstanding shares the company will have after going public]. And finally, you artificially underprice the offering. As in pricing the IPO lower than the pent up demand should call for! Yes, you read right.

See, when banks start selling the new offering, they have a list of “friends” (institutional funds) that they call FIRST to take orders. Don’t wait for their call because you will not get it. All of the new shares have been sold BEFORE the stock begins trading (this is the way it works). Some existing shareholders (VC, founders) may have the opportunity of selling in that block as well. There is no room left for retail investors. We then have a situation where a – demand for the shares has been artificially engineered and b – the offering has been sold at an artificially low price to privileged buyers who have special relationships with the underwriting banks. [For a textbook case of what I am discussing, look at the Alibaba IPO].

On the first day of trading, investors wanting to acquire shares will find none available. Except if they want to buy them at a much higher price than the IPO price. Et voila. You have your nice tech IPO “pop”. Those lucky enough to have been on the “list” will now be able to sell at a premium what they were offered at an artificially low price. Understand that the only thing that matters is the delta between the purchase price and the selling price, a profit that can be realized in a matter of weeks, if not days. The bankers get a fat underwriting check. And they can play that game again with the warrants that are part of their underwriting contract.

Then reality sets in because, at some point in time, those who wanted to sell have done so, putting a downward pressure on the stock price (since liquidity of the stock is drying up). And the stock price begins to drift and we have the “drop” (in the now common “pop-and-drop”). Unless of course, the company releases amazing results because, after all, that is why you should own a stock: for the privilege to partake in future growth, future earnings and future dividends (well, forget dividends for tech companies unless you are Apple or the like). Unfortunately, for most tech companies going public, these are months, if not years away. If you, as a retail tech investor, bought a stock at or near the IPO, you have probably bought “high”, saw the stock drifting down…and now have to cope with the end of the lock up period where short sellers are swarming like sharks over a dying whale. Meanwhile, you hope that the company’s results can live up to its hype. [Anybody remembers Groupon? Went public at about $25, traded at $3.62 last Friday]

Lesson #3. Never, ever buy a tech stock at or near the IPO. Take a look at the 12-months trading charts of the most well-known tech companies. They all go through the same patterns. But when that artificial dust has settled down, you can then identify real quality companies worth owning (suggest you take a look at two charts: Facebook and Twitter for a contrast). Whereas short term gains can be engineered (count on Wall Street to do that), long term gains cannot for they are based on true value creation. Unless of course you like to gamble :-)

About Philippe. I have had a very fun life so far, and I am not done yetJ. I am helping high-tech businesses get off the ground and turning around faltering businesses. I am the father of a wonderful 23 years old daughter. I am also a passionate dressage rider.