What is an IPO or Initial Public Offering?

IPO or Initial Public Offering is a process where a private company offers shares to the public for the first time and becomes a public company. Thus, in an IPO, two things happen.

  • A Private Company sells its ownership to the public for the first time to raise capital.
  • It becomes a public company after that.

For example, a private company is a business entity primarily owned by its founders, management, or a group of private investors. However, a public company has all or some portion of public ownership. Thus, a private company raises capital from the public through an IPO and becomes a public company.

There are various people and organizations like Angel Investors, Venture Capitalists, High Networth Individuals, Private Equity Firms, etc. invest in a private company along with the founders of the company. However, it becomes difficult for the company to meet its capital requirements when it wants to expand its business or introduce new products or services.

Thus, it plans to bring IPO to raise the required capital. Besides that, IPO helps both parties. It helps the company to collect a large sum of money. Similarly, a common man can become a partner of the company with a small investment and be a part of the company’s growth story.

Note: Banks, insurance companies, mutual funds, NRIs, and even foreign institutional investors invest in an IPO.

This post is the foundation course on the stock market. Thus, you need to read between the lines if you are a novice. Further, it will be a long session. However, the knowledge will pay you back.

an introduction to the primary and secondary market

You must have heard about the stock market. It is like other markets where you buy or sell something, i.e., vegetable market, cotton market, etc. However, in the stock market, stocks or shares are purchased or sold.

What is a share?

A share is a unit of ownership in a company. Further, the persons or organizations that hold the shares of a company are called its shareholders. They are partners of the company.

For example, you started ABC company with an initial capital of Rs 100. Thus, you have one share, and your ownership is 100% in that company.

Next, your friend Samir invests another Rs 100. Thus, your share capital is Rs 200 now. Therefore, both of you have 50-50 ownership with two shares. That means you will share the profit of 50% each.

Further, eight more people come and invest Rs 100 each. It means your total share capital becomes Rs 1,000, and the total number of shares becomes 10. It means each of you owns 10% of the company. Thus, you will share the profit of 10% each.

You notice that with each entry of a shareholder, the share capital increases, but the ownership percentage of the existing investors shrinks.

It was just a simple example to introduce you to share. However, we will learn more about the topic in our subsequent sessions.

The primary and secondary market

We can divide the stock market into two categories.

  • Primary Market
  • Secondary Market

As the name suggests, in the primary market, companies issue shares to the public for the first time. However, it never means that the company came into existence for the first time. For example, the Indian Railway Catering and Tourism Corporation (IRCTC) was established in 1999, but it issued shares to the public for the first time in 2019, after a gap of 20 years.

Thus, in the primary market, you buy shares directly from the company. And, the money goes to the company or its early investors. It opens for the public for a limited time. Thus, you have to apply for the IPO in that specific time frame.

However, once you get share allotment in the primary market, you cannot sell it back to the company if you change your decision. Then, where can you sell the shares?

The secondary market is the answer. The secondary market includes stock exchanges in India. Once the company allots shares to the public, it has to list its shares in major stock exchanges in three days.

Further, once shares of the company are listed, you can buy or sell shares anytime during the working hours of any business day. There are two major stock exchanges in India. They are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Both are located in Mumbai.

Note: The stock exchanges in India are open from 9.15 am to 3.30 pm, excluding holidays.

Thus, in the primary market, you buy shares from the company when it brings IPO. But, you buy or sell the shares of the company in the secondary markets. You can understand it better with the following illustration.

The illustration

primary and secondary market
primary and secondary market

In this illustration, we observe that ABC Company brings IPO. And Mr. X, along with other investors, invests in its IPO. He paid the required amount and got shares in his Demat account.

Once the IPO process is complete, and the ABC Company lists its shares in India’s major stock exchanges. Then, people like Mr. X can sell their shares or buy more on the stock exchanges.

Note: when you buy or sell shares in stock exchanges, you deal with other investors, not with the company. Thus, in a stock market, shares of a company only change hands.

What is an IPO?

As we discussed earlier, IPO or Initial Public Offering is a process where a private company issues shares to the public for the first time and becomes a public company.

Generally, companies create new shares in IPO. We call it Fresh Issue. However, in some cases, the promoters or the company’s existing shareholders sell their shares to the public. It is called Offer for Sale or OFS in short.

The promotors have to obey the guidelines set by the SEBI regarding their shareholding pattern. Thus, they cannot offload all of their stakes. But, they can only sell some portion of their stake to the public.

However, other existing investors, like Angel Investors, Venture Capitalists, or PE Firms, can ultimately exit the company by selling their shares to the public.

Thus, in an IPO process, the following things can happen.

  • The company issues new shares (Fresh Issue)
  • Existing investors sell some or all of their stake (OFS)
  • Or both new shares are created, and the existing investors sell all or some of their stake. (Fresh Issue + OFS)

An example

Let’s see an example of SBI Cards and Payment Services Ltd. that had brought IPO in March 2020.

SBI Cards IPO
SBI Cards IPO Credit: chittorgarh.com

The total issue size of this IPO was 137 million shares. However, a significant portion of it (130 million shares) was OFS, and only 6.6 million shares were new issues. Thus, it contained both a fresh issue and OFS.

Two major promotors of the company, i.e., Carlyle Group and State Bank of India, were offloading their stake through this IPO. Thus, a significant portion of the capital raised would go to these two promotors. For example, it amounts to more than 98 billion rupees (total size of 103 billion).

Finally, a small percentage of capital raised through the IPO would go to the company as there are other expenses also, i.e., IPO related fees.

Note: The company can raise capital further using another option called FPO or Follow-On Public Offer.

Learn More

To learn about  FPO or Follow-On Public Offer, click here.

Why do companies bring IPO?

The most apparent reason for a company to bring IPO is to raise capital. You know that a company needs money to expand its business, meet its working capital needs, clear-off its debt, or launch new products or services.

why do companies bring ipo

There are two ways a company can raise capital. One is debt; another one is equity. For example, it can take a loan from a bank called ‘Debt.’ Similarly, it can ask people to invest capital and become their partners, called ‘Equity.’

But, companies prefer the path of equity in most cases. The reason for this is simple; they don’t have to pay any interest. For example, if a company takes a bank loan, it has to repay it along with interest from the next month. However, it will take months or even years for the company to make a profit.

On the other hand, the company does not need to pay anything to its shareholders. Then, why shareholders invest in a company if the company does not give them anything.

Shareholders get returns in the form of dividends and capital appreciations. For example, when a company makes a profit, and the board decides to share a certain percentage of profit to its shareholders, it declares dividends. However, each company has a different dividend distribution policy. Some cash-rich companies, e.g., Oil & Gas Companies, Utility Companies, Software Companies, prefer to pay a higher percentage of dividends than other types of companies. However, a company doesn’t need to pay dividends.

Note: Dividend Income may range from less than 1% to more than 12% per annum on your investment.

Similarly, suppose you bought a share of Rs 100, and it becomes Rs 200 in four years, then we call it capital appreciation. We will discuss it more in our subsequent sessions.

Other reasons for bringing IPO

Other reasons to bring IPO may be creating brand awareness among people. For example, the IPO increases the prestige or public image of the company.

During an IPO process, the company needs to advertise its products and services to people in the media. It also conducts road-shows for advertisement. Thus, people know the company, its business verticals, products and services, its promoters, etc. It increases the demand for its products and services. Therefore, both the image and profitability of the company increase.

Once the image, credibility, and profitability of a company increase, it attracts talented people. Further, the company offers the Employee Stock Ownership Plan (ESOP) to encourage its employees to do what is best for shareholders. Thus, it helps to improve the performance of the company. We will discuss ESOP in detail in our subsequent sessions.

Further, the company must comply with the norms set by stock exchanges and the Security & Exchange Board of India (SEBI). For example, it has to publish its quarterly financial reports. Thus, the company has to report every little change that happens within it. It brings transparency and thus helps the company to raise capital further.

IPO also helps existing investors like PE Firms, Venture Capitalists, etc. to exit. When companies are tiny in size, they invest in those companies, particularly startups, and exit, when they become big, is size. It helps them to find another startup and invest their money. They generally take high risks with their capital. Even promoters can sell part of their stake to the public.

These were some of the reasons that attract companies to bring IPO.

Note: The list is not absolute. There are more reasons for a company to go public. However, I have mentioned only those that are essential for beginners.

The entities involved in the IPO Process in India

The IPO process in India is a complex one and requires the participation of several entities. However, you need not go through the details. Thus, I have simplified it in the post.

Hers is the list of some of the major entities involved in an IPO process.

The Investment Banks_also called Merchant Banks or Lead Managers.

They are banks but have expertise in IPO management. Further, they play a significant role from IPO initiation to listing the company in the stock market. For example, JP Morgan, Goldman Sachs, Axis Capital Limited, and Edelweiss Financial Services Limited, etc. play the role of Lead Managers in India.

Registrar to the issue

It is the ultimate record-keeper of shares and shareholders. Thus, it has a long term relationship with the company. For example, KFin Technologies Private Limited, Karvy Computershare Private Limited, Alankit Assignments Limited are a few examples who work as Registrars to issue in India.

Underwriter

Underwriter plays an essential role in the IPO Process. It is responsible for pricing, selling, and organizing the IPO. Further, it assures the company to buy the unsubscribed portion of its share up to a fixed percentage or amount. Banks, Lead Managers, etc. play the role of underwriters and are registered under SEBI.

Stock Exchanges

The company also needs to make listing applications to significant stock exchanges in India where it wants to be listed. For example, India’s major stock exchanges include the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Both these two exchanges are located in Mumbai.

Depositories

There are two depositories in India. They are the National Securities Depository Limited (NSDL) and Central Depository Services (India) Ltd (CDSL). Depositories are like banks. For example, you keep money in electronic form in banks. Similarly, shares are held in electronic form in depositories. We also call it in ‘Dematerialized Form’ or Demat Form.

Escrow Banker

The company appoints an escrow banker with an escrow account. An escrow banker is a bank but assigned for a particular purpose (here for IPO). Thus, whenever you apply for an IPO, your bank blocks the amount. Further, the escrow banker enters your details in the escrow account opened in the company’s name.

Registrar of Companies

The Registrar of Companies (ROC) comes under the Ministry of Corporate Affairs. A public limited company needs a certificate from ROC to exist. The company has to submit two essential documents Memorandum of Association (MoA) and Articles of Association (AoA) to get the certificate.

The role of SEBI

SEBI or Security & Exchange Board of India is the ultimate boss of the financial market. It is the supreme authority that sets rules, regulations, and procedures of IPO. Thus, a company needs its approval before it brings IPO. The company needs to submit a Draft Red Herring Prospectus (DRHP) to get approval. Here is a sample of DRHP for your reference.

DRHP is a document that details the company’s promoters, its reason for going public, the business verticals, the financial data, and the associated investment risks. It is like the horoscope of the company that includes everything about the company. Thus, it becomes an essential document for investors.

However, SEBI scans all the details and instructs the Lead Managers to make necessary modifications. Then, the DRHP becomes Red Herring Prospectus or RHP. Thus, RHP is the SEBI approved version of DRHP. Once, RHP is validated, the company can bring IPO.

However, RHP still lacks some vital information like IPO share price, the number of shares issued, issue size, etc. Because, these figures can only be confirmed once bids are received, and share price is fixed in a book building IPO. Thus, another document comes to the picture called ‘Final Prospectus’ that includes all the details as mentioned above.

Types of IPO

There are two types of IPO. One is Fixed Price and another Book Building.

Fixed Price Issue

Under Fixed-Price IPO, the company determines a fixed price at which it offers shares to the public. Therefore, investors know the share price before it goes public.

For example, when a company declares that it will issue 100 shares at the price of Rs 100 per share, we call it a fixed price IPO.

Book-Building IPO

However, in a book building issue, the company, in collaboration with lead managers, fixes a price band to discover the right price.

For example, Suppose ABC Company fixes a price band of Rs 100-110 and a tick size of Rs 5. It means people can bid on Rs 100, Rs 105, or Rs 110 only.

The lower price in the price band, Rs 100, is called the Floor Price. Similarly, the highest rate in the price band is called the Cap Price, Rs 110.

You cannot buy one or two shares of the company in the IPO, but you have to buy in lots. To take an example, suppose ABC Company sets lot size as 135. Then, the total amount you have to spend will be like this.

  • You have to pay minimum Rs 13,500 if you bid on the floor price (Rs 100 * 135 shares)
  • Similarly, you have to pay minimum Rs 14,175 if you bid on Rs 105 (Rs 105 * 135 shares)
  • Finally, you have to pay minimum Rs 14,850 if you bid on cap price (Rs 110 * 135 shares)

The price that receives a higher number of bids is called ‘Cut-Off Price.’ Thus, investors who bid below the cut-off price may not get their share allotment.

Note: The cap price can not be more than 120% of the floor price in an IPO as per SEBI guidelines. For example, Rs 120 is 120% of Rs 100 (the floor price). Thus, ABC company cannot increase the price band above Rs 120 in this book building IPO.

Today, book building IPOs are popular as SEBI discourages fixed price IPOs.

Learn More

To learn the IPO allotment Process, click here

How to invest in an IPO?

In India, you need to invest around Rs 10,000 – 15,000 in an IPO. Further, you need a Demat Account, a Trading Account, and a Bank Account to invest in an IPO. If you possess all these accounts, then you can apply an IPO either online or offline.

For online applications, you need to visit your broker’s platform. Similarly, you can also apply through your bank’s ASBA (Applications Supported by Blocked Amount) service.

For offline, you need to visit your broker’s nearest branch. You need to submit the application form along with a cheque. Similarly, you can also submit the application to your bank that provides ASBA service.

Today, you can even apply IPO through Andriod Apps like PhonePe or Grow App. It is fast and easy. However, you need a Demat Account, Trading Account plus a Bank Account whatever way you apply.

If you need an initial handholding either in opening a Demat Account plus Trading Account or investing in an IPO, you can contact me on my WhatsApp number given at the end of the post.

A final thought on IPO 

IPO investing is becoming popular in India. Both Traders and Investors want a piece of the cake. You know traders try to make a profit in the short term. Thus, IPO investment is a good option for them. They even take loans to invest in IPOs and exit their positions once they are listed in the stock market. However, it is quite risky.

On the other hand, some people analyze and research the company and invest in an IPO. They have a long term view of the company. Further, a well managed and profitable company never trades below its issue price. Thus, they don’t prefer to book their profits for a 10-25% gain.

We can use the example of IRCTC to understand the concept better. The IPO of IRCTC opened on 30th September and closed on 3rd October 2019. Further, the price band was Rs 315-320. And, its lot size was a minimum of 40 shares.

Suppose, Mr. X is a trader and applied for only one lot at cap price. Thus, he had to invest Rs 12,800 only (Rs 320 * 40 shares). Then, IRCTC listed on stock exchanges on 14th October 2019. And, its share price closed at Rs 727.75 per share. Thus, Mr. X got a 127.42% return in just 11 days. You might be thinking that it was a good deal.

However, the current share price of IRCTC is around Rs 1335.85 (closing price of 31st July 2020). So, it is a 317.45% return. However, all IPOs do not give you such stellar returns, but well-managed and profitable companies do.

Thus, whenever you find a good IPO, don’t trade it, just stay with it for long. I am sure you will not regret it.

Thanks and regards,

finguru@finlessons.com

EXPLORE MORE POSTS

2 thoughts on “What is an IPO or Initial Public Offering?”

LEAVE A COMMENT

error: Content is protected !!