Ready to Buy That IPO? Read This First.

Facebook (NAS: FB) shares have sunk nearly 20% since their first day of trading. Splunk (NAS: SPLK) is down about 25% since closing on its first day. Millennial Media (NYS: MM) is off by more than half. It seems that initial public offerings give retail investors like you and me a chance to buy into hype but fail to produce solid returns. But is that just anecdotal evidence? Are the number who get burned by IPOs just more vocal than those who win big? Unfortunately, no. Read on before you dive into the next big IPO.

Jay Ritter, a finance professor at the University of Florida, builds mountains out of IPO data going back to 1980. His research offers many insightful takeaways based on solid statistics that can cut through the hype of the IPO world.

The first observation
Firms backed by venture capital perform worse for investors.


Today, some of the popular venture capital (VC) firms include Accel Partners (which invested more than $12 million in Facebook in 2005), Sevin Rosen (backers of Splunk), and Bessemer Venture Partners (which helped fund Millennial Media). But between 2001 and 2010, newly public VC-backed companies returned just over 4% over three years compared with non-backed companies that returned more than 18%:

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In previous decades, VC-backed IPOs actually outperformed non-backed companies. In the 1980s, VC-backed firms returned 33% compared with non-backed firms that returned 19%. In the 1990s, taking out the bubble year of 1999, VC-backed firms returned 60% compared with non-backed firms that returned 28%.

But with today's finicky markets, VCs seem to want to take the market risk out of their potential returns and delay going public until they can command a high price. As evidence, there were just 1,300 IPOs in the 2000s, compared to more than 4,000 in the 1990s and more than 2,000 in the 1980s. And since VC firms already see fantastic returns at the outset of going public, they don't have to worry about future performance, which leads to the next takeaway.

The second observation
Over three years, IPOs usually perform worse than both the market and similar companies.

With little reason to worry about future performance, VC-backed companies have languished in the 2000s. Compared with the market, VC-backed firms returned more than 8 percentage points less over three years. Compared with similarly valued companies with offerings at least five years ago, VC-backed firms returned more than 15 percentage points less over three years.

Adding in past decades, IPOs haven't performed much better. Since 1980, the average three-year return for all IPOs returned 19 percentage points less than the market.

Moreover, it's questionable whether Facebook and its peers really needed the capital that going public offered. Facebook's registration statement admitted that the company didn't "currently have any specific uses of the net proceeds planned."

Compare this with Annie's (NAS: BNNY) and Ignite Restaurant Group (NAS: IRG) , which had more immediate uses for going public by taking part of their IPO cash and paying down debt. The fact that some companies that go public don't immediately have a use for the cash leads to our third takeaway.

The third observation
VC-backed firms leave more money on the table compared with non-backed firms.

Those huge first-day price gains for VC-backed firms average 28% compared with non-backed firms of 13%. While this may make new shareholders wealthy, the company loses out on extra cash that it might have put to use for the long term. Make certain to look at a company's use of proceeds from an IPO. If a company has no use for the new cash, question what incentive it has to go public, and whether the IPO will help or hurt the company in the immediate future.

Taken with a grain of salt
As read in a million other financial documents, this past performance of IPOs does not reflect future performance. A VC-backed IPO could easily outperform the market, even if it has no stated use for the cash it raised, if any. But based on the data, you should have a strong conviction of a newly public company's prospects if you are going to invest.

For one IPO pick not mentioned above that The Motley Fool thinks is worth its price, read our free report: "Forget Facebook -- Here's the Tech IPO You Should Be Buying".

Editor's note: A previous version of this article incorrectly referred to a secondary offering for Splunk and erroneously said that Millennial Media received none of the proceeds from going public. The Fool regrets the error.

At the time this article was published Fool contributor Dan Newman holds no position in any of the above companies. Follow him on Twitter, @TMFHelloNewman. The Motley Fool owns shares of Facebook. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

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