When a private company needs to raise money and sell its shares to the public for the first time, it announces an Initial Public Offering (IPO). In other words, it is the sale of securities publicly on the primary market for the first time.
As an investor, you should understand that not all companies are successful when they issue their stock publicly. Therefore, when you are investing in an IPO, you should be aware of the pros and cons of the same.
What is an IPO?
An IPO is a process by which a private company offers its shares to the public through the issuance of shares . Through this process, the company can raise capital from Retail Investors, High Net Worth Individuals and Qualified Institutional Investors.
The primary market deals with new securities that a company issues for the first time. When listed on the stock exchange, the company gets permission to trade publicly and sell its stocks in the open market.
Though an IPO might be quite a costly process, at the same time, it makes it easier for the company to gain capital from what the investors invest when the company floats their IPO. The capital that the organisation gets after listing on the stock exchange ultimately helps in its expansion and other business plans.
What Are the Benefits of Issuing an IPO?
Opting for an IPO has several benefits over keeping the company private. Here are some of the significant pros of IPO you might want to be aware of:
- Raising Capital
It might never be possible for a company to raise such substantial amounts of capital in a short time without going public. This alone justifies its decision to opt for an IPO as this substantial funding can drastically change a company’s growth trajectory.
The funds can benefit a growing company and offer financial stability. It can help in research and development, acquiring new assets, recruiting new staff, paying off debts, buying new technologies, and financing capital expenditures.
Once listed on a stock exchange, the company gains more recognition and credibility. Listed companies need to provide periodic information about their business activities. Therefore they become more reliable for all its stakeholders like investors, suppliers and employees.
A publicly listed company is usually more well-known than its private rivals. It attracts more attention among investors as these organisations are seen as more efficiently run with effective corporate governance practices.
The cost of capital is one of the most significant costs for every organisation. Before going public, a company may need to accept loans at higher rates from the lenders. However, by opting for an IPO, organisations can significantly lower the costs for obtaining new financing.
- Stocks as a Means of Payment
Public companies can use their shares as compensation. Though private companies can also utilize their stocks as payment, it is valuable only if a favourable exit opportunity arises. Public stocks are much more useful as compensation as people can buy and sell them in the secondary market.
- Higher Valuation
Companies that are listed on the stock exchange have investors competing between themselves to purchase their shares. Due to this factor, the share price of these companies goes higher. At times the price might go abnormally higher though most of the time the price reflects the fair valuation. As stocks make it possible to put a price tag on public sentiments and firms, many successful businesses see their valuation soar when it is listed.
What Are the Risks of Issuing an IPO?
Despite a number of benefits, Initial Public Offerings might not be a perfect solution for all organisations. This is due to some of the major challenges mentioned below:
- Higher Costs
Initial public offering process is expensive. Apart from the ongoing cost of regulatory compliance for public companies, IPO transactions also involve expenditures for appointing an investment banker, an underwriter, and an advertiser for taking care of the entire process seamlessly.
- Market Pressures
Market pressure can be really difficult for the company leadership. Due to market volatility, these companies are under great pressure to maintain the value of their stocks at high levels. Executives are at times unable to take risky decisions as these might have a negative impact on stock prices. Though the founders of the company might have a long-term strategy, they might somehow face problems in execution while maintaining short-term and profit-driven views of the stock market.
- Potential Loss of Control
Public companies are directly answerable to shareholders rather than the promoters or founder of the company. Though the board of directors might authorise the management to oversee day-to-day business operations, the ultimate decision-making rests on the shareholders who can change/remove the CEO and even the founders.
- More Administrative Work
Unlike private companies, public companies have to submit their financials every quarter to the stock exchanges. Preparing such statements and auditing as a part of the disclosure procedure can cost a lot of money.
While applying for an IPO, several details are required to be included in the application and documentation. This might also include certain data that the company did not want to disclose. However, in order to participate, the company has to provide them.
An Initial Public Offering might or might not be the right step for a company. An IPO comes with many advantages and disadvantages. If you are considering floating an IPO, you should weigh all the pros and cons before making the decision.
Frequently Asked Questions
Does IPO always give profit?
It is not necessary that an IPO will always give profits. However, if you invest in the right company, there is a significant chance of securing gains.
What percentage of IPO is profitable?
On average, out of 10 IPOs, only 2 or 3 can be profitable and will make money. Fundamentally, investors should only invest in strong companies.
Is IPO better than stocks?
In terms of short-term returns, IPOs can be better than stocks as some IPOs come with strong listing gains. However, high-quality stocks may outperform in the long run.
Do IPO usually go up or down?
There is no specific way to consider whether an IPO will perform well or not. According to the company’s business performance and demand, the stock price after IPO can go up or down.
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk.