What is an IPO? A Comprehensive Guide to Initial Public Offerings
All companies need to raise funds to invest in new projects and grow. Firms can raise capital through equity, debt, or invest their retained earnings back into the business. An Initial Public Offering (IPO) is a way for established companies to raise equity capital. In this article, we will understand what an IPO is, how it works, and its benefits & drawbacks to a company.
What is an IPO?
An Initial Public Offering (IPO) is the process by which a privately owned company issues its shares to the public for the first time. It transforms the company from being a privately owned entity to a publicly traded one. An IPO is one of the methods through which companies can raise required capital by issuing shares.
An IPO can have two parts: a fresh issue and an offer for sale (OFS).
- A Fresh Issue refers to when a company sells new shares to the public for the first time. These shares have never been traded publicly before.
- Through an Offer for Sale (OFS), existing shareholders like founders, early investors, or employees of a company sell their shares to the public. These shares were previously held by insiders and are now being sold to external investors during the IPO.
Thus, an IPO is also a method for early investors and founders to exit their investments.
Why Do Companies Go Public?
Companies decide to go public for various reasons:
- Capital Generation: One of the primary reasons for an IPO is to raise capital. Going public allows a company to access a more extensive pool of investors and generate funds for various purposes, such as expansion, research and development, debt reduction, or acquisitions.
- Liquidity for Existing Shareholders: An IPO provides an opportunity for existing shareholders, including founders and early investors, to sell their shares and realize the value of their investments.
- Enhanced Visibility: Being a publicly traded company increases visibility and credibility, which can attract customers, partners, and additional investment opportunities.
How Does an IPO Work?
An IPO is a complex and time-intensive process. Here's a basic outline of how an IPO works:
1. Deciding the Mode of Raising Capital
The primary step in an IPO process is to decide how a company (say, XYZ Private Ltd) wants to raise capital. It can raise funds through equity or debt. XYZ can borrow money from banks, venture capitalists, private equity firms, and other financial institutions to meet its financial needs. However, borrowing may be unfavourable for companies at times, especially when it's in the initial stages and needs more cash flow to service the debt.
Once the company decides to raise capital through equity, it must decide whether to raise it privately or publicly. IPO is an option for raising capital publicly.
2. Appointment of Investment Bankers
Before a company files for an IPO, it needs to prepare its financial statements, undergo audits, ensure regulatory compliance and satisfy requirements. It will appoint investment banks and underwriters that perform various functions on behalf of the company. These entities act as intermediaries between the company and its investors. They also prepare the prospectus, decide how much money to raise and when, and help the company price its issues.
What is a Prospectus?
A company going public in an IPO issues a formal document known as a prospectus to the Securities & Exchange Board of India (SEBI). This document offers detailed information about the company, including its financials, operations, risks, and the number of shares it plans to offer. This data helps potential investors make informed decisions. It also explains how the company plans to use the proceeds of the issue.
SEBI regulates the entire IPO market in India. It ensures transparency and compliance in the IPO process. There are multiple types of prospectus such as Draft Red Herring Prospectus (DHRP), shelf registration prospectus, etc.
3. Registration for IPO
The company and an investment bank prepare a registration statement and a Red Herring Prospectus (RHP). It is the most important document that a retail investor has access to. You can use the RHP to evaluate the offer. The document contains all the information about the company and its IPO, except the price or quantity of shares that will be offered.
4. Cooling-Off Period
This is the time when SEBI verifies the facts disclosed by the company. It looks for errors, omissions, and discrepancies. The company can set a date for the IPO only after SEBI approves the application.
4. Application to Stock Exchanges
The company submits an application to the stock exchange where it plans to list its shares. In India, a company can list its shares on the National Stock Exchange (NSE), Bombay Stock Exchange (BSE), or both.
Two types of IPO pricing mechanisms exist - fixed price issues and book build issues. In a fixed price issue, the price at which shares will be sold and allocated is made known to the public in advance. Meanwhile, in a book-building issue, the issuer only reveals a range of prices (known as a price band). We will discuss more about both of these mechanisms.
6. Public Subscription
Once the company announces the IPO date, you can apply for it. Most brokers (like Zerodha, Groww, Fyers, etc.) offer the option to apply for IPOs from their terminals.
Additionally, you can apply for an IPO through the Application Supported by Blocked Amount (ASBA) option offered by banks. You can obtain IPO application forms from designated banks or brokers. Interested investors fill in the details in the form and submit it along with a cheque. SEBI has set five working days for the availability of IPO forms to the public.
7. Going Through With the IPO
After finalising the IPO, stakeholders and underwriters together determine the allocation of shares to investors. Typically, investors receive the entire requested amount of shares unless the IPO becomes oversubscribed. The allotted shares are then deposited into their Demat accounts, while refunds are issued in the event of oversubscription.
Following allocation, the company's shares start trading in the stock market. The company must prevent insiders from trading to avoid manipulating IPO stock prices.
IPO shares are distributed to bidders within 10 days of the conclusion of the bidding period. In cases of oversubscription, shares are allocated proportionally among applicants. For instance, if the oversubscription is five times the available shares, an application for 10 lakh shares will only receive an allotment of 2 lakh shares.
Benefits & Drawbacks of IPO
The benefits and drawbacks of opting for an IPO are as follows:
|IPOs offer a significant influx of capital for business expansion.||The IPO process involves huge expenses, including underwriting fees, legal costs, and compliance expenses.|
|Provide liquidity to early investors and employees, allowing them to cash out their shares.||Going public means giving up some control of the company as shareholders gain voting rights.|
|IPOs increase a company's visibility and credibility in the market, attracting more investors and potential partners.||Public companies face rigorous reporting and compliance requirements, which can be time-consuming and expensive.|
What is Oversubscription and Undersubscription?
- Undersubscription occurs when the number of shares available for purchase exceeds the demand from investors. In this case, not all shares are allocated or sold, which means that the IPO may not achieve the intended capital-raising goal.
- Oversubscription happens when the demand for shares surpasses the number of shares available. In such cases, shares are distributed based on predetermined criteria or proportion among applicants. Investors may receive fewer shares than they requested. Oversubscription can reflect high investor interest in the IPO and may lead to a successful capital raise for the company.
IPO Pricing Methods
There are two methods through which companies price their IPOs:
Fixed Price Issue
A Fixed Price Issue is a straightforward method for determining the initial share price in an IPO. In this approach, the company and its underwriters (entities that are responsible for assessing and assuming the risk of another party) decide a fixed price at which the IPO shares will be offered to the public. This predetermined price is typically based on various factors, including the company's financial performance, market conditions, and valuation.
In a Fixed Price Issue, all shares are made available to the public at the same fixed price, irrespective of the level of demand from investors. This simplicity and predictability can be attractive to retail investors, as they know exactly what price they will pay for the shares in advance.
However, a drawback of this approach is that it might not effectively consider market dynamics, which could result in missed opportunities if the price is not set optimally. In cases of oversubscription, investors may receive a proportionate allotment based on their subscription amount.
Book Build Issue
A Book Build Issue offers a more flexible and demand-based approach to determining the IPO share price. Rather than fixing the price in advance, the company and its underwriters set a price range within which investors can bid for shares. This price range is known as a price band. It includes a floor (the minimum price) and a cap (the maximum price).
Institutional and retail investors then submit their bids, specifying both the number of shares and the price they are willing to pay within the defined range. The final offer price is determined by assessing the demand generated throughout the bidding process. It's set in a way that ensures the sale of all available shares. This approach allows for real-time adjustments to the price, considering market demand and dynamics.
Investors who place bids at or above the final offer price usually receive the shares they requested, but those who bid below it may receive a partial allocation or none at all. Book Build Issues are generally seen as offering better price discovery because they take into account market feedback and adjust to investor sentiment and demand.
What is Lot Size in an IPO?
A "lot" refers to a specific quantity of shares that are offered for sale as a single unit in an IPO. The company going public and its underwriters determine the lot size. Investors who participate in the IPO can bid for and purchase shares in these predefined lots rather than selecting an arbitrary number of shares. The lot size may vary from one IPO to another. It ensures a fair distribution of the offering among investors.
Who are the Key Players in an IPO?
Various individuals and entities collaborate to ensure the successful execution of the IPO. The key players in an IPO are:
1. Company Management
The company's top executives, including the CEO, CFO, and other key officers, are responsible for making strategic decisions regarding the IPO. They are actively involved in the planning, preparation, and execution of the offering.
2. Underwriters/Investment Banks
Investment banks serve as intermediaries between the company and the public markets. They help structure the IPO, conduct due diligence, market the shares to potential investors, and facilitate the pricing and distribution of the shares. They also underwrite the issue, which involves assuming the financial risk of purchasing the shares from the company and re-selling them to investors.
Investment banks help the company make strategic decisions related to the IPO, including the timing of the offering, the pricing of shares, and the overall financial strategy.
3. Legal Counsel
Legal advisors help the company navigate the complex regulatory and legal requirements associated with an IPO. They ensure compliance with securities laws and regulations, draft necessary legal documents, and provide guidance on disclosure obligations.
4. Accountants and Auditors
Accounting firms assist with financial reporting, auditing, and ensuring that the company's financial statements comply with accounting standards. Independent auditors validate the company's financial statements and ensure their accuracy. They offer confidence to potential investors regarding the company's financial health.
5. Regulatory Agencies
In India, SEBI oversees the IPO process. SEBI reviews a company's prospectus and other documents to ensure that the company discloses all necessary information accurately and meets regulatory requirements.
Institutional investors (e.g., mutual funds, pension funds) and retail investors participate in the IPO by purchasing shares. Their demand and interest in the offering play a significant role in determining the success of the IPO.
7. Stock Exchanges
The shares of a company are listed and traded on a stock exchange after the IPO. The exchange ensures that the company meets listing requirements and facilitates the trading process.
In conclusion, an IPO represents a significant milestone in a company's journey, helping it raise capital, gain exposure, and become publicly traded. For investors, it offers opportunities to invest in exciting companies early in their public life. However, it's essential to approach IPOs with careful consideration, conduct thorough research, and align your investment with your financial goals and risk tolerance!