IPO – Full form, meaning and in depth analysis

Jul 30, 2022

In 2017, India released 36 Initial Public Offerings (IPOs)which resulted in companies raising a record amount of Rs 67,147 crore in the equity market through just IPOs.

With so much buzz created around it and money being raised in this astonishing manner, you might be wondering, “What exactly is an IPO?”

What is IPO?

The transition of a company going public from private is called Initial public offering (IPO). An initial public offering is the first time a company issues its shares to the public. 

When An unlisted company (A company which is not listed on the stock exchange) announces an initial public offering (IPO), it decides to raise funds by selling securities or shares to the public. In other words, an IPO is the selling parts of the company to the public in the primary market.

Criteria for IPOs

The following are the eligibility norms for companies planning to file an IPO as stipulated by SEBI.

  1. The company should have had net tangible assets (defined as physical assets plus monetary assets of at least 3 crore rupees in each of the last three years. Doesn’t include virtual assets with fluctuating value like shares)
  2. The company should have had an operating profit of minimum 15 crores for at least three years in the preceding five years.
  3. The size of the IPO can’t exceed the company’s worth by more than five times.

Even if these criteria are not fulfilled, the company can still file a request for approval of an IPO with SEBI. But, for such approvals, the IPO can only take the book building route where 75% of the stock has to be sold to Qualified Institutional investors (QII). This has to be done for the sale of stocks under the IPO to be held as valid. Otherwise, the IPO is canceled and the capital raised has to be returned.

SEBI functions to protect the interests of investors while ensuring that norms aren’t too stringent to dissuade prospective companies that have the potential and the vision to deliver growth.

Types of IPO 

There are two types of IPOs. A fixed price issue where the price of shares is fixed and a book building issue where the shares are set after the closing date of the bid.

Fixed price Offering 

Under fixed price, the company going public determines a fixed price at which its shares are offered to investors. The investors know the share price before the company goes public. Demand from the markets is only known once the issue is closed. To partake in this IPO, the investor must pay the full share price when making the application.

Book building IPO 

Under book building, the company going public offers a 20% price band on shares to investors. Investors then bid on the shares before the final price is settled once the bidding has closed. Investors must specify the number of shares they want to buy and how much they are willing to pay. Unlike a fixed price offering, there is no fixed price per share. The lowest share price is known as the floor price, while the highest share price is known as the cap price. The final share price is determined using investor bids.

Procedure 

  • A private company decides to raise capital through an IPO.
  • The company contracts an underwriter, usually a consortium of investment banks which assess the company’s financial needs and decide the price/price band of shares, number of shares to be offered etc.
  • The underwriter then participates in the drafting of the application (to SEBI) for approval with details of the company’s past financial records including profits, debts/liabilities, assets and net worth. Also, the draft mentions how the funds to be raised will be used.
  • SEBI carefully scrutinises the application and after making sure that all eligibility norms are fulfilled, it gives the company the go ahead to release the ‘red herring prospectus’.
  • The ‘red herring’ prospectus is a document released by the company mentioning the number of shares and the issue price/price band (price of one share) to be offered in the IPO. It also has details of the company’s past performance.
  • In what is called a ‘Road show’, executives travel to meet with and woo potential investors to buy their company’s shares.
  • An IPO opens and can last for 3-21 days, though it is usually open for 5 days.
  • During this time, retail investors can bid for stocks through their banks/brokerages via the Internet. 
  • Investors need to have a demat account to participate in an IPO, and a PAN card.
  • If the stocks you bid for are allotted, they’ll be credited to your demat account. If not, you’ll get your money back.

Pros

One of the key advantages is that the company gets access to investment from the entire investing public to raise capital. This facilitates easier acquisition deals (share conversions) and increases the company’s exposure, prestige, and public image, which can help the company’s sales and profits.

Increased transparency that comes with required quarterly reporting can usually help a company receive more favorable credit borrowing terms than a private company. 

Cons 

Companies may confront several disadvantages to going public and potentially choose alternative strategies. Some of the major disadvantages include the fact that IPOs are expensive, and the costs of maintaining a public company are ongoing and usually unrelated to the other costs of doing business.

Fluctuations in a company’s share price can be a distraction for management, which may be compensated and evaluated based on stock performance rather than real financial results. Additionally, the company becomes required to disclose financial, accounting, tax, and other business information. During these disclosures, it may have to publicly reveal secrets and business methods that could help competitors.

IPO performance 

An IPO is affected by several factors. which is often closely watched by investors. Some IPOs may be overly hyped by investment banks which can lead to initial losses. However, the majority of IPOs are known for gaining in short-term trading as they become introduced to the public. There are a few key considerations for IPO performance.

Lock up 

If you look at the charts following many IPOs, you’ll notice that after a few months the stock takes a steep downturn. This is often because of the expiration of the lock-up period. When a company goes public, the underwriters make company insiders, such as officials and employees, sign a lock-up agreement.

Lock-up agreements are legally binding contracts between the underwriters and insiders of the company. it is prohibiting from selling any shares of stock for a specified period. The period can range anywhere from three to 24 months. Ninety days is the minimum period stated under Rule 144 (SEC law) but the lock-up specified by the underwriters can last much longer. The problem is, when lockups expire, all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realise their profit. This excess supply can put severe downward pressure on the stock price.

Waiting periods 

Some investment banks include waiting periods in their offering terms. This sets aside some shares for purchase after a specific period. The price may increase if this allocation is bought by the underwriters and decrease if not.

Flipping 

Flipping is the practice of reselling an IPO stock in the first few days to earn a quick profit. It is common when the stock is discounted and soars on its first day of trading.

Can Anybody Invest in an IPO?

Oftentimes, there will be more demand than supply for a new IPO. For this reason, there is no guarantee that all investors interested in an IPO will be able to purchase shares. Those interested in participating in an IPO may be able to do so through their brokerage firm. although access to an IPO can sometimes be limited to a firm’s larger clients. Another option is to invest through a mutual fund or another investment vehicle that focuses on IPOs.

IPO price determination 

When a company goes IPO, it needs to list an initial value for its new shares. Underwriting banks do this to market the deal. In large part, the fundamentals and growth prospects establishes the value of the company. Because IPOs may be from relatively newer companies, they may not yet have a proven track record of profitability. Instead, comparable may be used. However, supply and demand for the IPO shares will also play a role on the days leading up to the IPO.

conclusion

Investors betting on an IPO can earn handsome returns if they are wise and have some expertise. The investors can form a choice by going through the prospectus of the companies initiating IPO. They need to go through the IPO prospectus carefully. To form an informed idea about the company’s business plan and its purpose for raising stocks in the market. However, one must be watchful and have a clear understanding of analysing financial metrics in order to identify the opportunities. you can choose platforms like LenDenClub where you can still get consistent high returns on Peer to peer investment allocation done by AI. A P2P model involves diversification of your fund into several small loans to mitigate risk. 

 

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