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MENTOR ME CAREERS

What is an IPO?- Explained

Author: Sarthak Bhalerao

Introduction:

An initial public offering (IPO) is a process of offering shares of a private company/corporation to the retail investors (public) and institutional investors before going public i.e., listing on the stock exchange where the shares will be traded.  An IPO allows the corporation to raise capital from the public/investors. In this article, I will explain what an IPO is, why a company decides to go public, the process of applying for the IPO and the different subscription status of the IPO. 

Table of Contents:

  1. What is an IPO?
  2. Why does a company go public?
  3. The application process of an IPO
  4. Subscription status of the IPO
  5. Conclusion

What is an IPO?

An IPO is a process where a corporation offers its shares to the public before its listing on the secondary market (stock market). The public refers to three sorts of investors viz. Retail Individuals, Non-institutional Investors (NII) and Qualified Institutional Buyers (QIB). 

The transition from a private to a public company can be very vital for the company’s private investors to get realised gains from their investment as the shares are usually listed at a higher price than their buying price. [1]

Why does a company go public? 

A company decides to file for an IPO to fuel their Capital Expenditure (CAPEX) requirements. There are many advantages to taking the company public. Following are a few examples: [2] [3]

  1. To raise funds to meet the needs of CAPEX.
  2. To pay off the debts of the company.
  3. The promoter spreads his risk amongst all the people who invest in the company which is beneficial for the promoter.
  4. Exit for early investors: When the company goes public, its shares are traded publicly on the market. Any existing shareholder such as the promoter, investor, venture capitalist, etc can use this opportunity to sell their shares in the market. By doing this, they get an early exit on their initial investment in the company.
  5. Improve visibility: The status and visibility of the company increases when traded publicly on the stock market. More and more people are interested in investing in the company which consequently results in creating a positive impact on its growth.
  6. To reward employees: Employees working for the company would have shares allotted to them as an incentive. This sort of option is known as the Employee Stock Ownership Plan (ESOP). These shares are allotted at a discount to the employees. 

Application Process of an IPO

Every step involved in the IPO must happen under the Securities Board guidelines. The following steps are involved [3] [4]:

  • Appointment of a merchant banker: A merchant banker assists the company with the various aspects of the IPO process such as conducting due diligence of the filing for an IPO to ensure its legalities, fixing the price band i.e., the lower and upper limit of the share price within which the company will go public, helping the company in promotional activities of the IPO, etc.
  • Applying to the Securities Board:The registration statement contains details regarding what the company does, the financial status of the company and why it wishes to go public.
  • Green Signal from the Securities Board:Once they get a go-ahead, they must provide information regarding the estimated size of their IPO, the number of shares allotted to the public, business model, financial statements, management details, etc. All this information is prepared in a document known as the Draft Red Herring Prospectus (DRHP). This document is circulated to the public. 
  • Fixing the price band: A price band is decided between which the public can bid for the shares.
  • Book Building/Fixed Price:Once the publicity is done and the price band is fixed, the company must open a window during which the public can subscribe for the shares. For example, if the company’s price band is 90-95, the public can apply for the lot by choosing a price in this range which they think is fair enough for the IPO. A lot is a fixed number of shares that if offered during the IPO. The public can only bid for the IPO in the multiples of lots. The process of collecting these price points along with quantities of known as Book Building. In a fixed price issue, the price at which shares will be sold and allotted is made known to the investors in advance.
  • Closure:After the book building window is closed, the price point at which the share is going to get listed is decided. This price point is usually at the price at which maximum bids have been received. 
  • Delivery of Shares: On this day, all the investors are credited with their allotted shares. These shares are credited to their account before the listing.
  • Listing: This is the day when the company gets listed on the stock market. From this day onwards, the shares of that company start to trade publicly.

Subscription status of the IPO:

According to the subscription status, we can see any one of the following cases: [5] [6]

  1. Oversubscription: If the demand for the shares is more than the number of shares allotted by the company to the public, the IPO is considered oversubscribed. In such a case, the shares are allotted to the public through a computerized lottery draw. Since this is a randomized lottery system, some investors will manage to get one lot each, while many will not be allocated with any shares.
  2. Small Oversubscription: In the case of a small oversubscription, let’s assume ABC company has 1000 allotted shares with a minimum lot size of 10 shares. According to SEBI, the maximum number of investors who can get at least 1 lot is 100 (1000/10). Assume a total of 100 investors have bid but 80 investors have bid for 1 lot and the remaining 20 have bid for 2 lots each. So, the total shares bid would be 1200 against the 1000 available shares. In this scenario, ABC company will allot one lot(10 shares) to each of the 100 investors and the remaining 200 shares would be distributed proportionately to the investors who have bid for more than one lot.
  3. Under subscription: If the subscribed shares are less than the allotted shares, the IPO is undersubscribed. In this case, every bidder receives the full allotment of the shares. The listing price is usually at a discount for undersubscribed IPOs. The remaining shares remain with the promoters of the company. These shares can be liquidated once the company is traded publicly.
  4. Severely undersubscribed: If the IPO is undersubscribed below 90%, the shares are forfeited, and the money is returned to the investors. This results in the company not going public

Conclusion: 

Once the shares are listed, they start to trade publicly on the stock market. The stock market is also known as the Secondary Market. Investing in a company’s IPO is a huge decision that requires thorough research of the company and its financials. The expertise of the merchant banker plays a huge role in a successful IPO. This allows many potential investors a new platform to invest and make money.

 

References

 

[1]

J. Fernando, “Investopedia Initial Public Offering Guidebook,” Investopedia, 01 March 2021. [Online]. Available: https://www.investopedia.com/terms/i/ipo.asp. [Accessed 05 September 2021].

[2]

K. Ashford and J. Schmidt, “Forbes Advisor: What is an IPO?,” Forbes Advisor, 11 August 2021. [Online]. Available: https://www.forbes.com/advisor/investing/initial-public-offering-what-is-an-ipo/. [Accessed 05 September 2021].

[3]

Karthik Rangappa, “Zerodha Varsity: IPO Markets,” Zerodha, 2014. [Online]. Available: https://zerodha.com/varsity/chapter/the-ipo-markets-part-2/?comments=all#comments. [Accessed 05 September 2021].

[4]

K. Bank, “Kotak Securities: What is the IPO process,” Kotak Securities, 2005. [Online]. Available: https://www.kotaksecurities.com/ksweb/ipo/ipo-process-explained-9-easy-steps. [Accessed 5 September 2021].

[5]

E. B. News, “Explained: How are shares allotted when an IPO is oversubscribed,” ETV Bharat, 19 July 2021. [Online]. Available: https://www.etvbharat.com/english/national/business/markets/know-how-are-shares-allotted-when-an-ipo-is-oversubscribed/na20210719151451541. [Accessed 5 September 2021].

[6]

I. Direct, “Knowledge center>Articles: ICICI Direct,” ICICI DIrect, 14 May 2021. [Online]. Available: https://www.icicidirect.com/knowledge-center/article//what-is-an-undersubscribed-ipo. [Accessed 5 September 2021].