What is IPO?

Initial Public Offering (IPO) refers to the process where private companies sell their shares to the public to raise equity capital from the public investors. The process of IPO transforms a privately-held company into a public company. This process also creates an opportunity for smart investors to earn a handsome return on their investments.

Investing in IPOs can be a smart move if you are an informed investor. But not every new IPO is a great opportunity. Benefits and risks go hand-in-hand. Before you join the bandwagon, it is important to understand the basics.

What is IPO in Stock Market?

IPO stands for Initial Public Offering. Initial Public Offering (IPO) can be defined as the process in which a private company or corporation can become public by selling a portion of its stake to the investors.

An IPO is generally initiated to infuse the new equity capital to the firm, to facilitate easy trading of the existing assets, to raise capital for the future or to monetize the investments made by existing stakeholders. 

The institutional investors, high net worth individuals (HNIs) and the public can access the details of the first sale of shares in the prospectus. The prospectus is a lengthy document that lists the details of the proposed offerings.

Once the IPO is done, the shares of the firm are listed and can be traded freely in the open market. The stock exchange imposes a minimum free float on the shares both in absolute terms and as a ratio of the total share capital.

Types of IPO

There are two common types of IPO. They are-

• Fixed Price Issue

Here, the company and underwriters analyze its liabilities, assets, and other financial data. They then fix the price per issue accordingly to achieve the targeted capital. The order document will justify the price with quantitative and qualitative aspects. Demand for securities will only be known once the issue is closed. Oversubscription levels are sometimes high for fixed price offerings. 

• Book Building Issue

Here, the price discovery takes place during the IPO process where there is no fixed price, but a price band. The lowest price here is the floor price and the highest one is the cap price. Investors may submit bids for their chosen share quantity at the price they wish to pay. Depending on these bids, the share price is fixed and securities are offered either above/equal to the floor price. Demand is known each day as the book building takes place. 

Fixed price methods may undervalue the shares of the company at the IPO, with the price mostly lower than the market value. Hence, they sell more and investors revalue the company positively accordingly. The book building system may ensure higher efficiency, matching the supply and demand of the shares before the price is fixed, without leaks. The company gets a fairer return and investors an upside since the price fixing takes place after the IPO closes.

IPO Advantages and Disadvantages

Investing in IPOs comes with both merits and demerits. Here are a few of the benefits and drawbacks you must know before making your investment decision.

Benefits of Investing in an IPO

Investing in an initial public offering withholds the below-mentioned advantages-

• Increased Recognition
  

When weighing the advantages and cons of an IPO, this good factor comes out on top. It assists management in gaining more reputation and credibility by becoming a trustworthy organization.

Companies that are publicly traded are typically more well-known than their private competitors. In addition, a successful process attracts media attention in the financial sector.

• Access to Capital
  

A corporation may never receive more capital than it raises by going public. A company's growth trajectory might be substantially altered by the substantial cash available. An ambitious company may enter a new period of financial stability following its IPO.

This decision can help R&D, hire new employees, establish facilities, pay off debt, finance capital expenditures, and purchase new technologies, among other things.

• Diversification Opportunity
  

When a corporation becomes public, its shares are traded on an exchange amongst investors. This increases investor diversity because no single investor owns a majority of the company's outstanding stock. As a result, purchasing stock in a publicly listed company can help diversify investment portfolios.

• Management Discipline
  

Going public encourages managers to prioritize profitability over other objectives, such as growth or expansion. It also makes contact with shareholders easier because they can't hide their issues.

• Third-Party Perspective
  

When a company goes public, it gains an independent perspective on its business model, marketing strategy, and other factors that could hinder it from becoming profitable.

Disadvantages of Investing in IPO

There are a few factors an investor would have to consider before starting to invest in an IPO-

• More Costs
  

IPOs can be quite costly. Aside from the continuous costs of regulatory compliance for public firms, the IPO transaction process necessitates the investment of capital in an underwriter, an investment bank, and an advertiser to ensure that everything runs well.

• Lesser Autonomy
  

Public companies are led by a board of directors, which reports directly to shareholders rather than the CEO or president. Even if the board delegated authority to a management team to oversee day-to-day business operations, the board retains the final say and the authority to fire CEOs, including those who founded the company.

Some businesses circumvent this by going public in a way that grants its founder veto power.

• Extra Pressure
  

In the midst of market turmoil, publicly traded firms are under enormous pressure to keep their stock values high. Executives may be unable to make hazardous decisions if the stock price suffers as a result. This occasionally foregoes long-term planning in favour of immediate gratification.

IPO Process

There are several reasons why a company goes public. They include raising funds for expansion, unlocking value for shareholders, and more. The IPO process usually involves the following steps: 

• Investment Bank Recruitment
  

  Companies first seek out the counsel of investment banks and underwriters to start the IPO process. This team analyzes the company’s financials and then signs the underwriting agreement with the details of the amount to be raised and the securities to be issued likewise. 

• Preparing the DRHP and RHP along with SEBI registration
  

  The next step is filing the registration statement (compulsory as per the Companies Act) along with the Draft Red Herring Prospectus (DRHP). The DRHP contains all the financial information, business and industry details, management information, probable price estimate per share, business plans, risk reports, and other mandatory disclosures.
  The documents have to be submitted to the local Registrar of Companies a minimum of three days prior to the offer being opened for the public for bidding. The Red Herring Prospectus (RHP) is then made while filing the application to the SEBI, containing the mandatory warning and other details.
  Upon complying with all SEBI guidelines and making all disclosures, the company gets the green light to go ahead. Alternatively, it may be sent back with a few comments at times which the company can resolve and file again for registration. Post approval, the IPO date is set and the financial prospectus is released accordingly. 

• Stock Exchange Application
  

  The company now has to finalize the stock exchange where it will list the shares. Companies can choose to list on both BSE and NSE as well .  

• Roadshows
  

  Prior to the IPO going public, there are usually two weeks where the company executives travel across the country to market the same to potential investors, majorly QIBs in major financial hubs. The agenda is to build interest  by presenting the data. Some large entities may also get a chance to purchase stocks of the company at a set price prior to going public. 

• IPO Pricing
  

  The price band is fixed through either of the two methods. The fixed price method is where the company works with underwriters for fixing a share price after analyzing various details. The book building method is fixing a price band within which investors may bid for shares, with final prices dependent on demand, received biddings, and target capital. Companies can set the cap price at 20% more than the floor price, with books open for three days for revising bids. Another aspect worth noting here is the IPO GMP or grey market price, which is the premium amount that investors are willing to pay prior to the shares listing officially on the exchange. 

• Going Public

The application forms are made available on a fixed date to the public who have to fill up the details and submit them with their payments. SEBI has fixed this availability period at 5 working days in most cases. Companies also have to choose the right time to offer their shares to maximize the earnings of the sale. Once bidding closes, the final prospectus is submitted to the SEBI and ROC. Investors usually get the full securities unless of oversubscription. These are credited to their demat accounts, with refunds in case of oversubscription. Upon allocating securities, the markets will start trading the IPO. The shares are then allotted to bidders within 10 days of the last bidding date.

Terms Associated with IPO

To have informed knowledge about IPO, it is necessary that one comes to know about some basic terms used in the process. Some of the commonly used terms are provided in the table below:

Any individual who is an adult and is capable of entering into a legal contract can serve the eligibility norms to apply in the IPO of a company.  However, there are some other inevitable norms an investor needs to meet.

Read more: What is IPO Listing Time?

The eligibility criteria are-

• It is required that the investor interested in buying a share in an IPO has a PAN card issued by the Income Tax department of the country.
• One also needs to have a valid demat account. 
• It is not required to have a trading account, a Demat account serves the purpose. However, in case an investor sells the stocks on listings, he will need a trading account. 

It is often advised to open a trading account along with the Demat account when an investor is looking forward to investing in an IPO for the first time.