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What is an IPO and How it Works

Last Updated : 02 Jan, 2023
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Stocks of publicly traded firms are traded on the stock market, and one way for a company to go public and have its stock listed on a stock exchange is through an initial public offering (IPO). Following an initial public offering, the company’s equity joins the general stock market and is subject to the same dynamics of supply and demand as other publicly traded equities.

What Is an Initial Public Offering (IPO)?

Initial Public Offering, or IPO, refers to the process of turning a privately held business into a public one. This technique also offers savvy investors the chance to generate a sizable return on their investment. A private firm can go public through an IPO by selling its stocks to the general public. A company that decides to list on an exchange and subsequently become public could be brand-new, young, or elderly. With the aid of an IPO, businesses can raise equity capital by issuing new shares to the public or by selling current shareholders’ shares to the public without generating any more funds. Whether a company is brand-new or has been operating for years, it might choose to go public through an IPO. Company insiders may use an IPO to diversify their holdings or generate liquidity by selling all or a portion of their private shares as part of the public offering. Companies typically issue an IPO to raise capital to pay off debts, fund growth initiatives, increase their public profile, or any of these purposes. A corporation has very few shareholders prior to the IPO. Founders, angel investors, and venture capitalists are all included in this. However, the corporation makes its shares available for public purchase during an IPO. Anyone can become a shareholder by purchasing shares directly from the business.

How does Initial Public Offering (IPO) Work?

In addition to preparing for an exponential increase in public scrutiny, a private firm seeking an IPO must also submit a massive amount of paperwork and financial reports. All these preparation is to satisfy the standards of the Securities and Exchange Board of India (SEBI), which regulates public companies. Because of this, a private company that intends to go public employs an underwriter—typically an investment bank—to provide advice on the IPO and aid in the determination of the offering’s starting price. A roadshow is a meeting with potential investors that is scheduled by underwriters to help management get ready for an IPO. In order to guarantee wide distribution of the new IPO shares, the underwriter assembles a syndicate of investment banking companies. A portion of the shares will be distributed by each investment banking group in the syndicate. When a business’s stock starts trading on a public stock market, such as the National Stock Exchange (NSE) or Bombay Stock Exchange(BSE), the underwriter issues shares to investors and the firm and its advisors agree on an initial price for the initial public offering.

Types of IPO or Initial Public Offering

There are typically two sorts of IPOs. When investors begin to purchase its stock, a company gains momentum. The two fundamental kinds of IPOs are

Fixed-Price Issue

The corporation and its underwriters evaluate the cost of the offers in this type of issue. They evaluate the company’s resources, obligations, and every aspect of its financial situation. They choose a price for their goods after examining these data. The price is established after accounting for all qualitative and quantitative factors. It’s possible that the fixed price in a fixed price issue will be undervalued during the company’s initial public offering. The price is typically less than the going rate. Because fixed price concerns consistently pique the interest of investors, the company ultimately experiences a good revaluation.

Book Building Issue

Instead of having a set price, a book-building issue has a price range. The lowest and highest prices are referred to as the “floor price” and the “cap price,” respectively. You are free to sell the shares you wish to purchase at the price you like. The stock price is then determined after analyzing the offers. The share’s demand is known at the end of each day as the book is being written. 

Why does a Company go Public?

There are several reasons why a firm will go public. Listed below are a few of the explanations why businesses choose to go public:

To Acquire Money for Development and Expansion

To expand operations, develop new goods, or settle debts, every business requires money. An excellent approach for a business to obtain this critical financing is to go public. Alternative funding strategies, such as loan applications, are more costly and risky. Based on their study of the company seeking a loan, banks provide a finite amount of money. When it comes to bank loans, the interest rates are typically hefty. On the other hand, an IPO can give the business a one-time cash infusion that can be put toward paying off debts, funding research and development, growing the business, etc. In other words, the likelihood that the business will grow is better if there are more funds available.

To Gain Publicity

The stock market calendar has IPOs “star-marked.” These events have received a great deal of attention and buzz. This is an excellent technique for a business to sell its goods and services to a new clientele in the industry. The IPO’s debut and increased visibility may also result in a boost in the company’s credibility. By frequently reporting to SEBI, the fiscal data can be made more transparent and thereby meet SEBI’s requirements.

Letting Owners and Early investors Sell their shares in Order to Profit

For initial investors and venture capitalists, it is also viewed as an exit plan. By selling its shares in an IPO, a firm can become liquid. In order to profit and leave the company, venture capitalists sell their stock at this point. A large amount of liquidity will be produced by selling the stocks. It will help the business achieve financial stability, enhancing price transparency. For stockholders who have been involved with the company for a long time, this can also provide a liquid entity.

Value Evaluation

Stock in a corporation is worth what an investor is ready to pay for it once it is listed on the exchange. Therefore, it informs third parties of the company’s present worth or value. For a business that wants to expand in the future and engage in mergers and acquisitions, value assessment is essential. Fundamentals and the rules of supply and demand are used to determine how much a company’s stock is worth in the financial world. 

Initial Public Offering (IPO) Process

Choosing an Investment Bank

When a business wishes to go public, it must work with an investment bank. These banks serve as market intermediaries during the firm listing process. The investment bank examines the financial statements of the company and assesses its value and dangers. Additionally, the investment bank takes on all duties and drafts a prospectus for potential investors. The investment bank is responsible for creating the first hype surrounding an IPO.

Draft Red Herring Prospectus(DRHP) Preparation for SEBI Approval

The investment bank and the business produce the registration statement and the DRHP to submit to SEBI after undertaking due diligence. Except for the asking price and the number of shares being offered, the DRHP provides all the information about the company. The SEBI regulator confirms the information provided by the company and looks for inaccuracies. The issuer must submit any adjustments back to SEBI if SEBI requests them. The draught prospectus is approved by SEBI after all application amendments have been accepted. The authorised prospectus is then used by the issuer and underwriter to advertise the IPO.

Roadshow

At this point, the business declares its intention to go public. Investment bankers and underwriters make every effort to visit as many financial institutions as they can around the world in order to have the greatest impact. Roadshows help sell the company’s prospects to investors. To share information about the IPO and the company, company leaders and underwriters might hold Q&A sessions and give multimedia presentations. 

Request to the Stock Exchange

The business submits an amended prospectus known as the Red Herring Prospectus(RHP) after receiving SEBI’s clearance. The IPO price is not, however, included in the RHP.

Value of Shares

An important IPO phase is determining the price and the number of shares, which is typically done a few days before to the firm listing. Companies select one of the two approaches listed below to determine share prices:

  • First situation is fixed price. The corporations in this situation offer a fixed share price. In both the final prospectus and the draft prospectus, both of which have been approved by SEBI, it is stated whether corporations choose to offer their shares at a set price.
  • The corporation may establish an upper and lower limit for the bidding process when it chooses not to issue the shares at a fixed price. This pricing range can be seen in a Red Herring Prospectus. It is a document that includes information about the issuing business minus the offer price and effective date.

Public Procurement

Once the company has decided on the IPO type they intend to issue, the shares are made available to the general public. The corporation can then allocate the shares in accordance after receiving applications from interested investors.

Purpose of an Initial Public Offering (IPO)

Company insiders may use an IPO to diversify their holdings or generate liquidity by selling all or a portion of their private shares as part of the public offering. Companies typically issue an IPO to raise capital to pay off debts, fund growth initiatives, increase their public profile, or any of these purposes. A private firm begins the IPO process once it is persuaded that it is necessary to go public.

Benefits of Investing in IPO

First-Mover Benefit

Particularly when reputable companies announce an IPO, this is true. Investors have the opportunity to purchase firm shares for a considerably lesser cost. This is due to the possibility of a rapid increase in share price once the company’s shares are traded on the secondary market.

Listing Perks

A firm may trade at a price that is either greater or lower than the allotment price when it is listed on the stock market. Listing gains occur when the starting price exceeds the allotted price. Investors typically anticipate that an IPO will do well after listing because of elements including market demand and favorable bias. 

High Profits

Investors may benefit from purchasing shares in an IPO if the firm has growth potential. The company’s strong fundamentals indicate that it stands a decent chance of expanding. You may benefit from this as well. Long-term, investors have a possibility to generate good profits.

Advantages and Disadvantages of an IPO 

Advantages of IPO:

  • By accepting investments from the entire investing public, the firm can raise money. This facilitates the completion of acquisition deals (share conversions) and enhances the company’s public image, reputation, and visibility, all of which can increase sales and profitability.
  • Due to the increased transparency that comes with mandatory quarterly reporting, a firm can typically benefit from more favorable credit borrowing terms than a private company.
  • Unlike loans provided by banks and other financial institutions, there is no requirement for a repayment period.
  • On the money raised, interest is not required to be paid.
  • Old debts may be settled using the monies raised.
  • Investors have a way out thanks to IPOs. After selling their remaining shares in the company, some venture capitalists have left the business. Following an IPO, the prices of the shares frequently increase once they are listed publicly. Therefore, when the promoters and investors decide to sell up their part, they could become wealthy.

Disadvantages of IPO:

  • An IPO launch is not a simple procedure. It involves a number of stages, such as selecting investment bankers, conducting roadshows, fixing share prices, obtaining SEBI’s approval, and finally coming public.. It is a protracted and important process that requires oversight at every level.
  • Public firms are required to file their financial statements annually, unlike private businesses. It suggests that the business should create an audit committee, financial reporting team, and more stringent financial controls. Because the corporation now owes its investors an explanation, reporting expenses may be considerable.
  • Private businesses are completely in charge of themselves. The IPO, however, enables the entrepreneur to share power with the other shareholders and investors. That founder is no longer able to run the company alone. He must include people in the critical business decision-making procedures.
  • A successful IPO requires both time and financial investment. There are upfront costs associated with an IPO. Underwriting fees, legal expenditures, accounting fees, registration fees, advertising expenses, etc. are some of them. These are nevertheless important and support carrying out the process correctly.

Alternatives of IPO

Direct Listing

A corporation can directly offer the public an investment opportunity through Direct Listing. When a company lists on a stock exchange, shares owned by management, employees, and private investors can publicly trade on the stock market without the need for additional funding. A firm that is already listed on another stock exchange or exchanges approaches BSE through the direct listing process to list its equity shares. Companies that meet the Exchange’s qualifying requirements are occasionally listed on the Exchange.

Terms Associated with IPO

Abridged Prospectus

This is a shortened version of the main IPO prospectus that includes all of the essential information about the IPO issue. According to the Indian Companies Act of 1961, all companies applying for an IPO must include an abbreviated prospectus with their application.

Stockbroker

Depository participants, like IIFL, let investors to purchase and sell shares and submit IPO applications. They offer investment services and make it easier to buy and sell shares during trading. The individuals who open an account are stockbrokers.

Fixed Price/Book Building

Fixed pricing and book building are the two ways that a company might launch its initial public offering. According to the set pricing, the business discloses the complete price of its IPO up front. The corporation establishes a pricing range and settles on the price using the Book Building process after determining investor demand.

Floor Price

The lowest bid price you can select when applying to an IPO is called the floor price. It is the bottom price cap in the price range a company has selected.

Issue Price

After the book-building IPO issue concludes, it is the price at which the shares are finally distributed to the applications. For each type of investor, a different issue price applies.

Cut Off Price

The shares are sold to investors at the lowest price possible, which is often reserved for ordinary investors. If your bid exceeds the cutoff price, you will receive a refund for the difference.

Oversubscribed/undersubscribed

The issue is deemed to have been oversubscribed if the firm receives more applications than the number of shares being made available. The IPO deal is considered undersubscribed if fewer applications are received than the number of shares being offered.

Bid Lot

Every investor submitting an application for an IPO must do so for a minimum number of shares known as a “Lot.” The business has already decided how many shares would be included in each of these “Lots.” Investors may submit applications for numerous lots.

Draft Red Herring Prospectus

Prior to the IPO process, the company issued an offer document in collaboration with SEBI and the Registrar of Companies. It encompasses the issue’s goals as well as all relevant operational and financial data, making it the holy grail of company analysis.

Anchor Investors

Qualified Institutional buyers, such as banks, financial institutions, mutual fund companies, etc., will get 50% of the IPO issue size. Anchor investors apply for shares worth Rs 10 crore or more under the QIB category. Anchor investors are given exclusive access to 60% of the QIB reservation.

Wrapping Up

Initial Public Offerings are generally regarded as advantageous since they enable the issuer company to expand its shareholder base and boost its visibility and reputation. At the same time, it gives investors a chance to earn substantial returns. To find the opportunities, one must, however, keep an eye on the most recent IPOs and have a firm grasp of analyzing financial metrics. IPOs are significant stock market events for a reason. There is a chance to make good profits over the long term by investing in the proper business. The challenge, though, is to separate the top achievers from the others.

FAQ’s on Initial Public Offers or IPO

1Q. What is IPO?

Ans: In a public offering, shares of a firm are offered for sale to institutional and often also ordinary investors. One or more investment banks typically underwrite an IPO and coordinate the shares’ listing on one or more stock markets.

2Q. What is IPO allotment?

Ans: Investors from various categories start submitting applications for shares as soon as an IPO is announced. It is referred to as an IPO allotment once the applied share is credited to their Demat & Trading account.

3Q. What are some examples of IPO?

Ans: Bikaji Foods International Ltd., Kaynes Technology India Ltd., Archean Chemical Industries Ltd., and Five-Star Business Finance Ltd. are the recently released IPOs. 

4Q. Is an IPO a Good Investment?

Ans: When you believe in the company’s long-term growth potential, only then does investing in IPOs make sense. However, investing in IPOs for a short period of time may be risky.



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