Last Updated on May 24, 2022 by Aradhana Gotur
The stock market is one of the most lucrative investment avenues in India. Investors trade in the stock market either through the primary market or through the secondary market. Of the variety of options available for investing in the primary market, applying to the Initial Public Offering (IPO) of a company remains the most attractive entry-point for investors, both short-term and long-term.
Table of Contents
Understanding initial public offering
IPO stands for Initial Public Offering. It is the process by which a private company can go public by selling its shares to the public. With an IPO, the company gets its shares listed on the stock exchange.
Before an IPO, a company is considered to be private – with a smaller number of shareholders, limited to accredited investors (like angel investors/venture capitalists and high net worth individuals) and/or early investors (for instance, the founder, family, and friends).
After an IPO, the issuing company becomes a publicly listed company on a recognized stock exchange that opens up a pre-decided quantity of shares for the public to trade. Thus, an IPO is also known as “going public”.
Process of IPO
The first thing that a company does before bringing an IPO is to hire a merchant banker to handle the process. An underwriting agreement is entered between the merchant banker and the company to work out the various financial details of the IPO.
The merchant banker underwrites the company’s shares by buying all or some part of the shares and selling them to the public. Later, both the parties file a registration statement with Securities and Exchange Board of India (SEBI) along with the underwriting agreement and necessary documents. SEBI then studies the details of the report submitted, and if the information presented is found correct, a date is allotted to the company to announce its initial public offering.
The initial listing fee of the company is Rs. 50,000 and depending upon the paid-up share capital of the company, the subsequent annual listing fee is determined. The company determines the share’s price band, and then the merchant banker offers its shares to the public.
Why does a company offer an IPO?
An IPO is a money-raising exercise. Every company needs funds to expand, improve business, better the infrastructure, repay loans, etc. Raising capital helps the company grow, innovate, expand and take risks. Capital raised through banks and other financial institutions could be expensive and a drain on the company in the long term. So primarily, to avoid traditional borrowing, a company may go public. Also, IPOs can help determine a company’s market capital structure.
Once the company has ‘gone public’ and the stocks are doing well, it becomes easy for businesses to grow further. Going public means that the brand has gained enough success to get its name flashed in the stock exchanges. It is a matter of credibility and pride to any company.
What is book building?
SEBI guidelines define book building as “a process is undertaken by which a demand for the securities proposed to be issued by a body corporate is elicited and built-up, and the price for such securities is assessed for the determination of the quantum of such securities to be issued through a notice, circular, advertisement, document or information memoranda or offer document”.
Book building is a process used in Initial Public Offer (IPO) for efficient price discovery. It is a mechanism (when the IPO is open) where bids are collected from investors at various prices, some above and many equal to the floor price. The offer price is determined after the bid closing date.
As per SEBI guidelines, an issuer company can issue securities to the public through prospectus in the following manner:
- 100% of the net offer to the public through the book-building process
- 75% of the net offer to the public through the book-building process and 25% at a price determined through book building.
What is a Draft Red Herring Prospectus (DRHP)?
A Red Herring Prospectus, the most important document for an IPO, is filed by a company to SEBI when it intends to raise money from the public by selling shares of the company.
The document is very useful to investors because it provides detailed information about the company’s business operations, financials, promoters and the company’s objective for raising funds by filing IPOs etc. It also elaborates on how the company intends to use the money raised and the possible risks for investors among others.
Advantages and disadvantages of investing in an IPO
Advantages of investing in an IPO
- Discounted price
Investing in a company’s IPO can give you a ‘cheap’ entry point, i.e., a price well below the stock’s intrinsic value. Many investment banks that decide the initial subscription price of a company’s share pre-listing offer the retail investors a sizeable discount to attract a larger pool of investors. Getting allotment in a credible business can reap multifold returns in the long run.
- Listing day gains
Although this is not a rule of thumb, companies that manage to create a notable hype pre-listing often witness block-buster listing day gains. This premium, in some cases, outperforms multi-year returns of certain legacy companies giving more incentives to investors to buy stocks early on.
- Early entry point
Every company seeking an IPO is doing so for a reason, i.e. they are amassing capital that can be re-invested in increasing capacity and production, introducing new product lines or exploring new markets. Whatever these initiatives may be, the business surely yields results of these investments over the long term. An investor who has entered a stock at the IPO stage can reap the benefits of these business decisions in the future.
Disadvantages of investing in an IPO
- Lack of published financial statements
Although every company heading for an IPO submits a detailed DRHP that publishes the company’s audited financial statements over the last three to five years, the business dealings of a private company are, by and large, private. As an investor, you can conduct limited due diligence into the past business of a company pre-IPO, which can be viewed as a credible risk.
- Limited visibility into the corporate structure
Many private companies’ corporate structure, from a pre-existing familial structure, may not suit larger corporations. Moreover, the transition to a more formal corporate governance may have a visible impact on the company’s business; this inexperience may cost investors their money.
Conclusion
IPO investments are generally considered by retailers for listing and short-term gains. An investor must not be blinded by the mammoth IPO success of the likes of a Paras Defence and Space Technologies or a Zomato. IPO majorly run on market moods, for instance, a bull market will help even a dull IPO shine out. Hence, one must be watchful of IPOs, as many also sub perform, which again can affect your gains.
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