What Is an Initial Public Offering (IPO), Know How IPO Works: Explained
What Is an Initial Public Offering (IPO), Know How IPO Works: Explained
Finance

What Is an Initial Public Offering (IPO), Know How IPO Works: Explained

There are thousands of companies that trade on the New York Stock Exchange (NYSE) and the Nasdaq. These companies range from the leviathan Apple to the smaller, more inconsequential companies, with market capitalizations of less than the price of a car.

Every last one of those companies had to start somewhere. They each sprang to trading life with initial public offerings (IPOs), turning from private companies to public ones, attracting investors and raising capital.

What is IPO?

The process of Initial Public Offering (IPO) transforms a privately-held company into a public company. This process also creates an opportunity for smart investors to earn a handsome return on their investments.

Investing in IPOs can be a smart move if you are an informed investor. But not every upcoming IPO is a great opportunity. Benefits and risks go hand-in-hand. Before you join the bandwagon, it is important to understand the basics.

IPO Meaning

Initial Public Offering (IPO) can be defined as the process in which a private company or corporation can become public by selling a portion of its stake to the investors. An IPO is generally initiated to infuse the new equity capital to the firm, to facilitate easy trading of the existing assets, to raise capital for the future or to monetize the investments made by existing stakeholders.

KEY TAKEAWAYS

  • An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance.
  • Companies must meet requirements by exchanges and the Securities and Exchange Commission (SEC) to hold an IPO.
  • IPOs provide companies with an opportunity to obtain capital by offering shares through the primary market.
  • Companies hire investment banks to market, gauge demand, set the IPO price and date, and more.
  • An IPO can be seen as an exit strategy for the company’s founders and early investors, realizing the full profit from their private investment.

What does it mean to the company?

When the general public like us invests in IPOs, it gives the company the responsibility to manage it efficiently so that the shareholders aren’t at a loss. This leads the company to make itself efficient and effective.

What does it mean to the investors?

When you buy a share in an IPO, you become a shareholder in the company. It means that you become the owner of that much part of the company which you bought the share for.

Let’s look at some interesting things related to IPOs.

You might have heard this on various media platforms that if you invest in so and so IPOs, you can earn lakhs in a day because of the listing gain. But is it true? The short answer is No.

Because first of all – you can’t invest unlimited money in an IPO. Which means that if you want to buy an ITC share, you can buy one for Rs 1000 or Rs 10,000 according to your wish. But you can’t do that in an IPO. Unlike shares, you can only buy IPOs in lots. So you could take one lot or you could take multiple, which usually adds up to around Rs 14,000 or Rs 15,000.

So, even if you get the listing gains and double your money, you’re going to get a maximum profit of around Rs 15,000. Hence, it’s not at all true that you’ll invest in an IPO and become rich overnight.

Secondly, the IPOs which are successful are oversubscribed. Take IRCTC for example, it was over subscribed 112 times! But what does that mean? It means that of the 112 people who applied, only one got the IPO. And you definitely have to be lucky to get this IPO amongst 112 people for Rs 15,000.

Now, the question is:

Should you invest in an IPO?

Again, let’s take an example to understand this. Suppose you want to buy an ITC share and you want to buy it for Rs 200. Now, there is also an investor who has ITC shares and he wants to sell it for Rs 210. In this case, there’s a seller and a buyer who negotiate and then decide to sell and buy the share for Rs 200, and hence the trade will get executed.

When we are trading shares, the price is negotiable. But this is not the case for IPOs. The prices are not negotiable.

Pros

  • Can raise additional funds in the future through secondary offerings
  • Attracts and retains better management and skilled employees through liquid stock equity participation (e.g. ESOPs)
  • IPOs can give a company a lower cost of capital for both equity and debt

Cons

  • Significant legal, accounting, and marketing costs arise, many of which are ongoing
  • Increased time, effort, and attention required of management for reporting
  • There is a loss of control and stronger agency problems

Eligibility norms required to invest in an IPO

Any individual who is an adult and is capable of entering into a legal contract can serve the eligibility norms to apply in the IPO of a company. However, there are some other inevitable norms an investor needs to meet. The eligibility criteria are:

It is required that the investor interested in buying a share in an IPO has a PAN card issued by the Income Tax department of the country.
One also needs to have a valid Demat account.
It is not required to have a trading account, a Demat account serves the purpose. However, in case an investor sells the stocks on listings, he will need a trading account.
It is often advised to open a trading account along with the Demat account when an investor is looking forward to investing in an IPO for the first time.

How to invest in an IPO?

There are certain steps the investor needs to follow to ensure that they are following the right path to wealth. The steps an investor needs to follow are:

Decision

The primary step for an investor would be to decide the IPO he wants to apply for. Though the existing investors may have the expertise, it could be an intimidating one for the new ones. The investors can form a choice by going through the prospectus of the companies initiating IPO.

The prospectus helps the investors to form an informed idea about the company’s business plan and its purpose for raising stocks in the market. Once the decision has been made, the investor needs to look forward to the next step.

Funding

When an investor has formed the decision regarding the IPO he would like to invest in, the very next step would be to arrange the funds. An investor can use his savings to buy a company’s share.

In case the investor does not have enough savings, he can avail a loan from certain banks and Non-Banking Financial Organisations (NBFCs) at a definite rate of interest.

Opening a Demat-cum-trading account

Any investor without a Demat account cannot apply for an IPO. The function of a Demat account is to provide the investors with the provision to store shares and other financial securities electronically. One can open a Demat account by submitting his Aadhaar card, PAN card, address and identity proofs.

The application process

An investor can apply for an IPO through his bank account or trading account. Some financial organisations will offer you the provision to bunch your Demat, trading and bank accounts.

After an investor has created the demat-cum-trading account, he needs to be familiar with the Application Supported by Blocked Account (ASBA) facility. It is mandatory for every IPO applicant. The ASBA is an application that enables the banks to arrest funds in the applicant’s bank account.

The ASBA application forms are made available to the IPO applicants in both demat and physical form. However, the use of cheques and demand drafts can not be made to avail the facility. An investor needs to specify his demat account number, PAN, bidding details and bank account number in the application.

Bidding

An investor needs to bid while applying for the shares in an IPO. It is done according to the lot size quoted in the company’s prospectus. Lot size can be referred to as the minimum number of shares that an investor has to apply for in an IPO.

A price range is decided and the investors require to bid within the price range. Though an investor can make a revision in his biddings during an IPO, it should be noted that he needs to block the required funds while bidding. In the meantime, the arrested amount in the banks earns interest until the process of allotment is initiated.

Allotment

In many cases, the demand for the shares can exceed the actual number of stocks released in the secondary market. One can also face situations where he can get a fewer number of shares than what he had demanded. In these cases, the banks unlock the arrested funds either entirely or partially.

But, if an investor is lucky enough to get a full allotment, he would receive a CAN (Confirmatory Allotment Note) within six working days after the IPO process is done. After the shares have been allotted, they are credited to the investor’s demat account.

Once the above-mentioned steps are carried on successfully, the investor will have to wait for the listings of the stocks in the share market. It is generally done within seven days after the shares are finalised.

Terms Associated with IPO

To have informed knowledge about IPO, it is necessary that one comes to know about some basic terms used in the process. Some of the commonly used terms are:

Issuer

An issuer can be referred to as the company or the firm who wants to issue shares in the secondary market in order to finance its operations.

Underwriter

An underwriter can be a banker, financial institution, merchant banker or a broker. It assists the company to underwrite their stocks. The underwriters also commit that they will subscribe to the balance shares in case the stocks offered at IPO are not picked by the investors.

Draft Red Herring Prospectus

The DRHP is the document that makes the public know about the company’s IPO listings after the approval made by SEBI. A DRHP contains the following information about the company:

  • Purpose of raising funds through listings
  • Balance sheet
  • Promoter’s expenses
  • Earning statement of the last three years (if applicable)
  • Net proceeds of the company
  • Commission and discounts of the underwriter
  • Details such as the name and address of all the underwriters, officers, directors and stockholder who possess 10% or more than the currently outstanding stock.
  • Legal opinion on the listings
  • Copy of the underwriting document

Fixed Price IPO and Price Band

Fixed Price IPO can be referred to as the issue price that some companies set for the initial sale of their shares.

A price band can be defined as a value-setting method where a seller offers an upper and lower cost limit, the range within which the interested buyers can place their bids. The range of the price band guides the buyers.

Under subscription and oversubscription

Under subscription takes place when the number of securities applied for is less than the number of shares made available to the public.

Oversubscription is the condition when the number of shares offered to the public is less than the number of shares applied for.

Green Shoe Option

It refers to an overallotment option. It is an underwriting agreement that permits the underwriter to sell more shares than initially planned by the company. It happens in cases when the demand for a share is seen higher than expected. It lets the issuer company release additional shares in the secondary market in the event of oversubscription.

Book Building

The process by which an underwriter or a merchant banker tries to determine the price at which the IPO will be offered is called book building. A book is made by the underwriter where he submits the bids made by the institutional investors and fund managers for the number of shares and the price they are willing to pay.

Once an idea has been made and the price band is decided, the underwriter or the merchant banker decides the IPO price. The issuer company’s shares are open for subscription for three trading days.

On a closing note

Initial Public Offerings are generally considered beneficial as it lets the issuer company enlarge their equity base and increases the exposure and prestige. At the same time, it provides investors with an opportunity to gain handsome returns. However, one must be watchful of the latest IPOs and have a clear understanding of analysing financial metrics in order to identify the opportunities.

Initial Public Offering (IPO)

An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance.

FAQ’s related to IPO

What Is a Hot IPO?

A hot IPO is an initial public offering of strong interest to prospective shareholders such that they stand a reasonable chance of being oversubscribed.

Learn About Secondary Offerings

A secondary offering is the sale of new or closely held shares of a company that has already made an initial public offering (IPO).

Flotation

Flotation is the process of changing a private company into a public company by issuing shares and encouraging the public to purchase them.

What Is an Offering Price?

An offering price is the per-share value at which publicly issued securities are made available for purchase by the investment bank underwriting the issue.

Capital Pool Company (CPC)

A capital pool company (CPC) allows emerging companies in Canada to go public through a buyout by a listed company with capital but no commercial operations.

What Is the Purpose of an Initial Public Offering (IPO)?

An IPO is essentially a fundraising method used by large companies, in which the company sells its shares to the public for the first time. Following an IPO, the company’s shares are traded on a stock exchange. Some of the main motivations for undertaking an IPO include: raising capital from the sale of the shares, providing liquidity to company founders and early investors, and taking advantage of a higher valuation.

Can Anybody Invest in an IPO?

Oftentimes, there will be more demand than supply for a new IPO. For this reason, there is no guarantee that all investors interested in an IPO will be able to purchase shares. Those interested in participating in an IPO may be able to do so through their brokerage firm, although access to an IPO can sometimes be limited to a firm’s larger clients. Another option is to invest through a mutual fund or another investment vehicle that focuses on IPOs.

Is it Good to Buy IPO Shares?

IPOs tend to garner a lot of media attention, some of which is deliberately cultivated by the company going public. Generally speaking, IPOs are popular among investors because they tend to produce volatile price movements on the day of the IPO and shortly thereafter. This can occasionally produce large gains, although it can also produce large losses. Ultimately, investors should judge each IPO according to the prospectus of the company going public, as well as their financial circumstances and risk tolerance.

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