As an investor, we look for suitable opportunities to invest in upcoming Initial Public Offerings (IPOs). However, before that, we should be aware of the whole IPO process. Companies usually strive to maximise their growth and they can do so by raising funds from the public by issuing their shares.
Let us understand how an IPO works and the whole process behind the same.
What Is an IPO?
An Initial Public Offering (IPO) is the process by which a company issues shares to the public for the first time. By doing so, a private company becomes publicly owned. This allows it to raise the funds necessary for its expansion, debt payment, or general corporate purposes.
Before the IPO, a company grows with the help of its founders, angel investors, venture capitalists and institutional lenders. When a company is successful in achieving a specific goal and its management realises that its systems and controls are stable enough to deal with the regulations and listing requirements of the Securities and Exchange Board of India (SEBI). This allows a company to use public funds to unlock the next phase of growth.
Through an IPO, ownership of a company is offered to both retail investors and institutions. After its IPO is over, shares sold in the primary market are listed on stock exchanges, allowing investors to freely buy and sell them.
IPO initiation helps infuse new equity capital into a firm, facilitates easy trading of existing shares, and raises capital for the future. It is also an excellent opportunity for existing investors to invest and earn returns on their investments.
Why Does a Company Go Public?
There are various reasons why a company decides to launch an IPO. Some of the most important reasons are as follows:
- To Raise Capital for Growth and Expansion
One of the greatest benefits of issuing an IPO is that it is instrumental in raising capital for the growth and expansion of a business. When a company is able to raise the capital, it can utilize it for research, better infrastructure, development as well as business expansion, etc.
- Increases Its Credibility
A company’s credibility can improve a lot in the eyes of investors when it goes public. As per the SEBI’s strict regulations, a company’s financial data will be accessible to the public. When people will be able to see the financial data, there will be much more transparency. As a result, investors will be more likely to trust the company.
- Value Assessment
Once a company gets listed on the stock exchange, its value will be what investors are willing to pay. Therefore, outsiders will get an idea regarding a company’s present value or net worth. Value assessment is extremely essential for a company that is willing to grow in the future.
How Are IPOs Issued?
When a company wishes to get listed, they advertise to underwriters by soliciting private bids or announcements in the form of a public statement to generate interest. The underwriter that the company chooses, leads the IPO process. An underwriter is usually a financial organisation that explores and evaluates the investor’s risk appetite and the company’s value for a fee in the form of commissions or interests. Here are the steps that a company usually follows to issue an IPO:
Step 1: Hiring an Underwriter or an Investment Bank
The company approaches several investment banks to act as financial experts and underwriters for the IPO process. These underwriters study the essential financial parameters of a company and then sign an underwriting agreement. The underwriting agreement usually consists of these components:
- Details of the IPO
- The amount that is to be raised
- Details of securities that are going to be offered
While making an agreement, the underwriters assure that they will raise capital and act as intermediaries between investors and the company.
Step 2: Registration for IPO
This step involves the company as well as investment banks creating a registration statement along with a draft prospectus. This is known as Draft Red Herring Prospectus (DRHP). Submitting the DRHP by the company and underwriters is mandatory according to the Companies Act.
All information about the business which falls under compulsory disclosure according to the SEBI and the Companies Act must be present in this document except the number of shares and their price. Here are all the key components of a DRHP:
- Definition: It contains the definition of all industry-specific terms.
- Risk Factors: This document must disclose all possibilities that might impact the company’s finances.
- Use of Proceeds: This section provides information about where funds raised by the issuer will be utilised.
- Industry Description: The document will provide details about the working of the company in the entire segment. For example, if a company belongs to the IT sector, information regarding prediction and forecast for the IT sector needs to be present.
- Business Description: Details regarding core business activities will be available in this section.
- Management: This section offers details about key management personnel.
- Financial Statement: It includes a financial statement along with the auditor’s report.
- Legal and Other Information: This section provides information regarding litigations against the company and other miscellaneous information.
This draft RHP (Red Herring Perspective) is to be finalised and a final RHP is submitted to the registrar of companies prior to the offer opening to the public for bidding. The registration statement needs to be compliant with the SEBI rules, only then the company will be able to apply for an IPO.
Step 3: Verification by the Securities and Exchange Board of India (SEBI)
After submission of the DRHP, India’s capital market regulator, SEBI, will verify all facts provided by the company. Once these details are verified, the application will go through an approval process by the SEBI. If no problems are found, the regulator will approve the IPO.
Next, the date and time are given for announcing an IPO. However, if the SEBI is not satisfied, it will ask the company to make necessary changes before the company can share its prospectus with the public.
Step 4: Application to Stock Exchange
Listing is the process through which securities are permitted to be traded on a recognised stock exchange. However, to make this happen, the company needs approval from the exchange.
To get this approval, a company sends an application form with the initial issue to the stock exchange and the listing department of the exchange grants approval for the securities of a company. The company needs to meet a list of criteria to be listed on the BSE and NSE. Some of these requirements include:
- The minimum issue size should be ₹10 crores.
- The company’s minimum post-issue paid capital should be ₹10 crores.
- The minimum market capitalisation of a company should be ₹25 crore.
Step 5: Creating Awareness in the Market
Before going public, a company will advertise its upcoming IPO in the market through company events, roadshows, etc. This includes the presentation of facts and figures to attract public investments. The objective of marketing is to create a positive interest among potential investors so that when the company goes public, they provide funds and buy its shares.
Even big corporations can purchase stocks in IPOs at a predetermined price.
Step 6: Pricing of IPO
The company can now decide whether it wants to initiate pricing of IPO through fixed price IPO or book building process. In case of fixed price issues, the company and its underwriters fix the share prices beforehand. To set the IPO’s price, a number of factors are considered including the company’s target capital, demand for its stocks, and its liabilities.
While in the case of the book-building method, the underwriters and company fix a price band within which investors can bid. The final prices however depend on demand for shares, target capital to achieve and bids received. As per the regulations, a company can fix a cap price that is up to 20% higher than the floor price.
Investors can place their bids according to the company’s quoted lot size, which is the minimum number of shares investors can purchase. Issuing companies can also provide the floor price or minimum bid price and cap price or maximum bid price to the investors.
The booking period goes on for three to five days when investors can revise the bid. After this, the company decides on the cut-off price at which the issue is finally sold.
Step 7: Allotment of Shares
After finalising the price, the issuing company along with its underwriters will decide how many shares will be allotted to each investor. It takes around 10 days from the last bidding day for allotting stocks to investors.
If there is a case of oversubscription, the issuer cannot allot shares to everyone who applied for the IPO. So, shares are allotted based on a lottery system. In case an investor does not receive any shares, they will receive a complete refund.
What Are the Benefits of Issuing IPOs for Companies?
Opting for an IPO comes with a huge number of benefits for companies over staying private, especially when their business grows rapidly. Here are some of the benefits of issuing an IPO for a company:
- Increases Liquidity
The employees, stakeholders, and equity investors work really hard to make the company achieve considerable success. While they are paid in the form of equities for their investment, they cannot easily make profits from these shares if the company is private. After the company goes public, it is the time for its employees, stakeholders, and equity investors to reap benefits by selling off their stakes.
- Facilitates Mergers and Acquisitions
When a company is publicly listed, it becomes easier to carry out mergers and acquisitions. Deals usually include shares when a public company is in talks about a merger or acquisition with a smaller competitor. In this manner, smaller companies can easily cash out.
- Improves Cash Flow Situation
Selling a company’s equity will help it with capital and liquidity. This can be utilised to improve the company’s future. The company will also be in a better position to cut down its cost of capital.
What Are the Benefits of an IPO for Investors?
The benefits of investing in an IPO are as follows:
- Listing Gains
In an IPO prospectus, the valuation of the company, as well as its offer price, and other important details, are mentioned. Investors can use this information to make an informed decision. If the share price on its listing day is higher than the issue price, investors can make a quick listing gain by selling the stocks on the secondary market.
- Fair Chance for Retail Investors
As per the rules and regulations of the SEBI, small retail investors get a fair chance to invest in an emerging company at a decent price. Many times, small investors do not get this chance in the secondary market.
- IPO Norms
As per the SEBI’s stringent norms, the company prospectus includes all relevant information such as performance, financials, risk, growth, and future plans of the company. This gives investors a chance to make informed decisions.
- Shareholder Ownership Authority
When an individual invests in an IPO and receives share allotment, he/she becomes a company shareholder. The investor also gets voting rights in shareholder meetings. So, this helps investors to raise their voices and express their concerns.
- Buying Cheap
When a company goes public, it offers its shares at a decent valuation. This is especially true when you invest in a small company that has the potential to grow big. Therefore, investors can buy shares at a lower price and create wealth in the long term if the company makes it big.
Limitations of Investing in IPO
Similar to any other investment, IPOs also come with certain limitations. Here are some of the limitations of investing in an IPO:
- You May Not Get Shares
There is no guarantee of receiving shares when someone invests in an IPO. If the company has good fundamentals, then many people will apply. And in case of oversubscription, every investor will not get a shared allotment.
- Pricing Risks
The price of IPO shares is decided after the company is listed. There is a possibility of the share price upon listing being lower than the purchase price. Moreover, the prices may continue falling down.
- Time Consuming
Before investing in an IPO, the investor needs to study the company as well as its past performance. He/she needs to go through the DRHP of the company. However, understanding it might be a tedious task as well as time-consuming.
Now that the steps of the IPO process and its importance are clear, investors can make informed investment decisions. To make prudent investment decisions the investor needs to take some steps. Two such steps are doing your due diligence by thoroughly going through the Red Herring Perspective and evaluating the present market sentiments before investing. Investment in IPOs can be tricky but at the same time, they can generate decent returns in the short as well as long term.
Frequently Asked Questions
Can companies get listed on stock exchanges without an IPO in India?
Yes, a company can get listed on the stock exchange without an IPO as long as they meet all the conditions that are set by SEBI. Such a direct listing is possible for companies that are listed on any recognised stock exchange.
What is a price band?
The price band refers to the minimum and maximum limit of the share price within which a company offers its shares to the public. Investors can bid between these minimum and maximum limits.
What are primary and secondary markets?
The primary market is a part of the capital market where newly created securities are bought and sold. Secondary market is the part of the capital market where investors buy and sell securities that they already own.
What is the role of a registrar of an IPO?
Appointed by the issuer company, the registrar of IPO manages IPO applications, allocates shares to applicants, and processes refunds and transfers of shares to the Demat account of IPO applicants.
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.