Primary Market : Functions, Types, Advantages & Disadvantages

What is a Primary Market?

A Primary Market is defined as a platform where securities or tradable financial instruments are introduced to the public for the first time. The governments, corporations, and other parties raise capital from investors by issuing equity or debt instruments in the primary market. The investors purchase these securities from the primary market and then trade them in the secondary market. All of this trading takes place in the stock market. As corporations or government agencies raise money from this market, there are underwriters or investment banks to facilitate this process. They determine a price range for a given security or financial instrument and then coordinate with the investors to sell the security. Once an initial selling of security is completed, the entire trading business shifts to the secondary market.

A Primary Market is where new bonds or stocks are introduced to the public for the first time. Here, the investors (public) can purchase stocks or bonds directly from the issuer (e.g., corporations).

How does the Primary Market Work?

1. The primary market works under the transactions system and for this process, three parties are involved: corporations or issuers, investors, and an underwriter.

2. A Corporation or Enterprise issues its stocks into the primary market as an IPO (initial public offering). The selling price of these new issues is set by a designated underwriter (not necessarily it be a financial institution). The new public offering is facilitated and observed by the underwriter. The underwriter or the investment banks who determine the securities’ initial price are given a commission by the issuer for the sale and the remaining amount is taken by the issuer.

3. Corporations or Government Entities issue new common and preferred stock, corporate and government bonds, notes, and bills on the primary market. They do so to expand their business operations or increase corporate capital. The corporations issue both debt and equity securities such as debentures and shares. On the other hand, the government issues treasury bills which are debt securities. These securities are released either at a face value, discounted value, or at a premium rate which transforms into debt and equity instruments.

4. These securities are issued in both international and domestic markets. In the primary market, investors purchase these newly issued stocks and bonds with a view of generating returns in the future by their investment. This form of market is under the regulation of the SEBI (Securities and Exchange Board of India). The primary market comes under the ambit of the capital market.

Functions of Primary Market

A primary market performs three main functions: offering, underwriting, and distribution.

1. Offering New Issue: The primary market is also termed as a New Issue Market (NIM) as new issues are being offered and released in the market for the very first time. Here, investors invest in brand-new issues that have not been introduced previously on any other platform. A detailed assessment of the viability of the project is conducted while offering a new issue. Therefore, the market and investors look into the debt-equity ratio, liquidity ratio, promoters’ equity, and other factors before considering the corporation’s issue.

2. Providing Underwriting Services: One of the essential functions while offering a new issue is underwriting. In a primary market, an underwriter acts as the intermediator between the investor and the issuer. The Underwriter also purchases the remaining shares from the market if the required number of shares are not sold in the market. They earn a commission for their job if the shares are sold in the market. The role of an underwriter can be played by a financial institution or an individual. They are relied upon by investors to assess whether taking on a risk will reap worthwhile profits. An underwriter may purchase the entire IPO issue and then trade it among the investors.

3. Distribution of the New Issues: In the primary marketplace, new issues are distributed via a new prospectus issue. In other words, new issues are offered to the investors, and enter the loop of trading. The company’s details, issues, and underwriter-related information are passed on to the public for purchasing the new issue. As the trading further occurs, those new stocks and bonds leave the primary market and enter the secondary market.

Types of Primary Market Issues

The primary market issues can be of different types, each having different purposes and fulfilling different needs. Some of the issues in the primary market are as follows,

1. Initial Public Offering (IPO): The first offering or sale of a company’s securities to the public is known as the Initial Public Offering (IPO). It is a type of public issue. IPO takes place when a private or public (unlisted) company decides to enter the stock market by issuing shares to investors. Here, an underwriter (investment bank or financial institution) determines the offering price purchases the securities from the issuer, and further sells them to the public. The public (or investors) become the shareholders of the issuing company. Thus, in an IPO, an unlisted company gets listed on the Stock Exchange.

2. Follow-on or Further Public Offering (FPO): Follow-on public offering is another form of public issue where the listed company in a stock exchange issues fresh securities to the public to raise additional funds.

3. Private Placement: Private placement is a type of issue where securities are sold directly to institutional investors (mutual funds, pension funds, or insurance companies) rather than the general public. This method is used by companies who might not meet the regulatory requirements for a public offering, i.e., small early-stage startups. Additionally, if we compare private placement and IPO, private placement is much easier to handle than IPO due to its regulatory norms and time consumption.

4. Rights Issue: In this type, a corporation offers its existing shareholders the right to purchase extra shares at a discounted or predetermined price. This helps the existing shareholders to maintain their part of ownership in the company and further, the company can raise additional funds without extra charges.

5. Preference Share Issue or Preferential Issue: This is one of the fastest types of raising capital for a company. Preference shares are securities that can act as both equity and debt. The shareholders having preference shares receive a fixed dividend before the normal shareholders and during the liquidation of the company, these shareholders hold a higher initial claim on the company assets than the normal shareholders. These types of issues can be used by both listed and non-listed companies.

6. Qualified Institutional Placement (QIP): QIP is a type of private placement where equity shares and partial or full convertible debentures (except warrants) are issued by the listed companies. Qualified Institutional Buyers (QIB) are the purchasers of these convertible issues. They are experts in the financial field and can be of different types: foreign venture capital investors, mutual funds, alternate investment funds, public financial institutions, scheduled commercial banks, pension funds, and issuers (these are registered under SEBI). Comparing QIP with preferential share issue, QIP is much simpler in terms of regulations with SEBI.

7. Bonus Issue: A bonus issue or scrip issue or capitalisation issue is a form of issue that offers free additional shares to the existing shareholders based on their proportional holdings. This method only increases the number of outstanding shares but does not raise additional capital for the company. These shares are issued from their securities premium account or free reserves.

8. Debenture Issue: A company issues a debt instrument known as debenture which has a fixed interest rate and a fixed maturity date. This type of primary issue may be secured, or unsecured and mainly represents a borrowing for the issuing company.

9. Government Securities Issue: Governments issue bonds and other securities in the primary market to raise funds for different purposes, for instance, budgetary needs or infrastructure development. These government securities can be purchased by investors comprising individuals, institutional investors, or foreign investors.

Examples of Primary Stock Market Selling

1. One of the well-known examples of primary stock market selling is Facebook, the giant social media company. Their initial public offering (IPO) was a remarkable one. In 2012, Facebook opened an IPO and they could raise around $16 billion. This was one of the largest IPOs in the technology industry. Their turnover increased by nearly 100% due to this IPO. There was a huge demand for the shares and hence the underwriters fixed $38 as the rate for each share in the primary market. Ultimately, the valuation of the company increased to $104 billion (among the highest newly formed public companies).

2. Another IPO (biggest in India) was undertaken by Coal India in the year 2010. They raised ₹15,200 crore. The shares had an initial pricing of ₹287.75 and later the price increased to ₹340. A 5% discount was offered to the retail investors, subsidiaries, and employees of the company, on the final IPO price.

Advantages of Primary Market

One of the major advantages of the primary market is that here the corporations can raise money directly from the investors. This enables them to pay off debts, fund their operations, and expand their business. A few other advantages are,

1. Capital Infusion: Corporations can raise a sufficient amount of capital by issuing new shares in the primary market. This helps the company in expanding its business, research and development, debt repayment or taking other strategic initiatives.

2. Market Presence: A company can increase its visibility and credibility in the market by attracting investors, analysts, and media if the company goes public through an IPO.

3. Transparency and Fair Pricing: Due to regulations from SEBI, transactions in the primary market are transparent and hence are a secure medium of investment. Further, the pricing of the securities is decided by the underwriters considering several factors leading to a fair pricing.

4. Subject to Low Risk: Companies offering securities via the primary market are subject to cut down on risk due to diversification. Investors can reduce their risk by investing in multiple financial instruments across the market. Further, the primary market is not exposed to market fluctuations and hence, the potential market risk does not affect the price of the securities as the price is set by the underwriter.

Disadvantages of Primary Market

The following are some of the disadvantages that a primary market can possess,

1. High Costs: The process of going public, especially through an IPO, can be expensive. Companies often incur significant underwriting and legal or regulatory fees including marketing expenses. This leads to a reduction of net proceedings from the issue.

2. Regulatory Obstacles: Companies going public must comply with extensive regulatory requirements, which can be time-consuming and may pose challenges. The SEBI has set out rules and regulations for going public which can be cumbersome and complicate the proceedings.

3. Dilution of Ownership: Existing shareholders may experience dilution of their ownership stake when new shares are issued in the primary market.

4. Risk of Over and Under Subscription: Small investors might lose out on share allocation if the shares are over-subscribed. Also, if the issue is not properly received in the market, then it might lead to under-subscription. Thus, both under and oversubscription are harmful to the issue.

5. Time-Consuming: The proceedings for issuing in the primary market is time-consuming as a company going for an IPO needs to initially hire an underwriter, then the underwriter would analyse and study the market and financials of the company and then decide on the further proceedings. This whole process takes a lot of time to finally raise the money from the market.

Difference Between Primary Market and Secondary Market

One of the major differences between the primary and secondary markets is that in the primary market, securities are issued directly from companies to investors while in the secondary market, securities are traded among the investors. The below table shows some other differences;

Basis	Primary Market	Secondary Market
Purpose	Involves the issuance of new securities.	Involves the trading of existing securities among investors.
Function	Companies raise capital by selling newly issued stocks or bonds.	Investors buy and sell previously issued stocks or bonds.
Participants	Underwriters, Investors, and Issuing companies.	Brokers, Investors, and Dealers.
Price	Fixed price determined by the underwriters.	Market-driven price based on market fluctuations.
Volume	A low volume of shares are issued.	A high volume of shares are transacted.
Regulated by	Solely regulated by the SEBI.	Regulated by SEBI and other stock exchanges.