Avoid These 2 Stocks When They IPO

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"Better-burger" chains Fatburger and Bobby's Burger Palace are planning to go public soon, and both intend to use the little-known Regulation A+ method to do it. While it is a novel path to take, and could give small investors a chance to get in early on stocks in a way that is usually reserved for big-money players, you would do well to steer clear.

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No failing grade

The Regulation A+ IPO process was created as a result of the 2012 Jumpstart Our Business Startups (JOBS) Act, which eased federal regulations and allowed small businesses and start-ups to raise money from individuals. If you've wondered why crowdfunding campaigns from Kickstarter, Indiegogo, and other platforms seem more prevalent today, well, there you go: The JOBS Act means businesses can gain access to a wider swath of investors' money without having to go public.

Yet Regulation A+ also let companies go public in what's been called a mini-IPO process, raising as much as $50 million from the general public, rather than just from accredited investors. It was an attempt by Congress to fix the many problems of Regulation A, which allowed such businesses to raise a maximum of $5 million from accredited investors while saddling them with exorbitant costs for state-by-state compliance. The revised rule eliminated that requirement, raised the limit on how much could be raised, and let in the little guy. In fact, hedge funds and other vehicles that pool money to invest in new companies are expressly prohibited from investing in Regulation A+ IPOs.

The path less taken

Certainly not a bad deal, but despite Regulation A+ being operational for several years now, very few companies have actually pursued the mini-IPO path. Three-wheel-car manufacturer Elio Motors (NASDAQOTH: ELIO) was the first to successfully go public using the new rule, but it trades over-the-counter. This year, Myomo (NYSEMKT: MYO) was the first to get listed on the NYSE while zero-emission and hybrid vehicle parts maker ADOMANI (NASDAQ: ADOM) was the first to go public on the Nasdaq using a mini-IPO. Since then, staffing specialist ShiftPixy (NASDAQ: PIXY) has joined it.

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The reason why so few companies have actually used Regulation A+ to go public is that many are not well-suited to convincing the public they would be good investments. It takes a lot of money to market a business to enough investors to raise sufficient capital, and beyond that, it's good to have a relationship with potential investors -- Fatburger and Bobby's Burger Palace are examples of companies that can make their case in a direct way to their customers. Finally, it requires a good market for IPOs generally, and last year wasn't so hot. In fact, Myomo actually cancelled its first planned 2016 Reg A+ IPO. This year is proving much better for IPOs, which may explain the sudden burst of interest in the Reg A+ variety.

Better burger bubble bursting

Yet Fatburger and Bobby's may not be the best stocks to buy through this process.

First, the better-burger bubble has burst. As Shake Shack's (NYSE: SHAK) latest earnings report indicates, the company is having trouble luring more customers to its stores, and its restaurants are generating less money as the chain opens more locations. In fact, most better-burger chains are still in a build-out phase, despite comparable-store sales falling across the board. Shake Shack's comps are down while The Habit's (NASDAQ: HABT) growth rate has fallen from 12.6% at the start of 2015 to a barely perceptible increase of 0.1% at the end of the second quarter.

Fatburger, which is looking to trade on one of the major exchanges, says it wants to use the mini-IPO path to raise $20 million to fund acquisitions. Its parent Fat Brands previously purchased a casual dining chicken wing chain, Buffalo's Cafe, opened a fast-casual version of it called Buffalo Express, and now wants to take such food global. The recent experience of Buffalo Wild Wings (NASDAQ: BWLD), however, which is trying a similar approach, albeit domestically, would suggest that won't be easy.

Also, CEO Andy Wiederhorn told Nation's Restaurant News that Fat Brands will only be IPO-ing a very small portion of the company; the parent will remain firmly in control.

Similarly, celebrity chef Bobby Flay is looking to expand his hamburger stand chain beyond its current 17 restaurants by licensing the brand globally. Bobby's Burger Palace is looking to raise $17 million from investors.

Look before you leap

Regulation A+ is a boon to small businesses and small investors, but they need to carefully pick and choose the companies they perform due diligence on. Fatburger and Bobby's Burger Palace may be good places to grab a bite to eat, but might not be the right spot for your money.

The better-burger space is burgeoning with concepts now, and these two chains want to expand even more, but buying into their mini-IPOs could be a big mistake.

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Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Buffalo Wild Wings. The Motley Fool is short Shake Shack. The Motley Fool has a disclosure policy.