ipo-investingIt is never a good idea to invest on hunches, rumors and hot tips. Similarly, it’s too risky to go all-in on stocks that just gained listing via an IPO without first doing your homework.

Blindly buying hot IPOs could put a big dent in your investment portfolio. No matter how hot the idea may seem, you really need more caution and analysis than bravado when it comes to IPO investing. That’s especially true in a thriving IPO market such as this; last week alone 28 IPOs were planned.

So if you want to be a player in the IPO market, what should you watch out for?

I always recommend that investors beware of the excessive cash-out by company founders and existing shareholders (remember that even private companies have shareholders). By completing an IPO, executives and current shareholders can cash out of their business while early investors bear the brunt if the stock price drops below its initial offering level.

One particular method of cashing out that I dislike is called the dividend recap. A dividend recap happens when a company takes on debt to pay a special dividend to founding partners, private investors or venture capital groups. It’s typically done as a way for these early investors to realize a gain, or as a way to remove some (or all) of their initial investment. It’s not necessarily part of the IPO, but may have occurred a few years earlier.

The dividend recap is great for these early investors who took on considerable risk. They certainly earned a reward. But it’s not necessarily great for new shareholders who want to buy stock in the company that completed the dividend recap, since the after-effects can linger for years.

For example, I was somewhat dismayed when I found out a company I was interested in, Fox Factory Holding (Nasdaq:FOXF), had completed a dividend recap in 2012. Fox makes high-end suspension products for mountain bikes, motocross and off-road vehicles.

While perusing Fox’s pre-IPO filing I noticed that the company paid a special dividend of $67 million in 2012.

To put this in context, Fox’s net income in 2010, 2011 and 2012 totaled $38.52 million. So the special dividend in 2012 amounted to 173% of the company’s trailing-three year net income. Ouch.

Long story short, I passed on FOXF in large part because of the dividend recap. And I’m glad I did since the event had drained the company of cash. The stock priced at $15 per share in August 2013 and after a volatile year is still trading at that level.

Now, don’t get me wrong. Executives certainly have the right to cash out. They took the risk to start a business and worked hard to turn a profit. And shareholders of the private stock also have the right to cash out; that potential is what fuels the venture capital industry and spurs entrepreneurship.

But that doesn’t mean that new shareholders should jump into the stock simply because it’s now public. And to be clear, the dividend recap is just one potential red flag to look out for. There are other more obvious signs of excessive cash-outs, too.

In summary, take a close look at what executives and founders are doing next, and where the proceeds of the IPO are going. If executives’ goals aren’t aligned with new investors’ interests, it could come back to haunt the company, and its stock price.

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Published by Wyatt Investment Research at