IPO Basics: Understanding Initial Public Offerings

An Initial Public Offering (IPO) is a fundamental aspect of our economy, often operating behind the scenes but playing a crucial role. It stands for “Initial Public Offering,” and essentially means a company is offering itself or its shares to the public for the first time. Many of the major corporations that dominate our economic landscape today reached their current positions by raising capital through IPOs. For individuals looking to make wise investment choices to grow their wealth, participating in an IPO can present a lucrative opportunity, provided they have a basic understanding of how IPOs work. In this article, we will explore the essential aspects of IPOs that you should grasp before considering investing in one.

Key Points

• IPO stands for Initial Public Offering, representing the moment when a company offers its shares to the public.
• In an IPO, a privately-held company issues new shares to the public, generating capital for the company’s expansion and growth.
• Regulatory approval for an IPO is necessary, and in India, it is granted by the Securities and Exchange Board of India (SEBI).

Understanding Company Ownership

Before delving into IPOs, it’s vital to comprehend how a company’s ownership structure functions. A company, in its traditional definition, comprises assets like capital, infrastructure, and human resources. It acquires raw materials and labor, rents or purchases infrastructure, and uses these resources to produce goods and services.

Companies can fall into two categories:

1. Privately Owned: This means the company is entirely funded by one or more private entities, and ownership remains within these private hands.
2. Publicly Owned and Traded: A publicly owned company is one where ownership is shared with the public through the sale of shares on stock markets. Individuals or institutions that invest in the company acquire shares and thereby ownership. These shareholders have voting rights, and collectively they influence the company’s decision-making process.

The company appoints a board of directors, often based on majority shareholder votes, and this board holds decision-making authority on behalf of the company.

What is an IPO?

An IPO, or Initial Public Offering, marks the first occasion when a private company offers its shares to the general public. In this process, the company issues new shares to the public, and the capital raised from this offering is used to facilitate the company’s growth. IPOs serve as a valuable means for rapidly expanding companies to secure the necessary capital, and they also provide the public with the opportunity to profit by owning shares in potentially profitable businesses.

It’s important to note that the majority ownership of private owners, including founders and promoters, becomes diluted once the company goes public through an IPO. Their influence and voting power can diminish, depending on the company’s governance structure.

How an IPO Works

Achieving approval for an IPO is not a straightforward task. Much like starting a new business, it involves several steps and significant regulatory scrutiny. In India, SEBI plays a critical role in approving IPOs. The process typically includes the following steps:

1. Application Submission: The company files an application with SEBI, providing essential details such as the number of shares to be issued, the IPO’s price (in the case of a fixed-price IPO), the company’s historical performance, and the intended use of the funds raised.
2. Red Herring Prospectus: After SEBI’s approval, the company releases a red herring prospectus. This document contains information about the company’s past performance and details about the IPO.
3. Lead Manager Selection: The company engages a lead manager, often an investment bank or brokerage, to oversee the IPO process.
4. Soliciting Bids: The lead manager invites bids for the IPO from investors, including financial institutions and sometimes retail investors.
5. IPO Subscription: During the IPO’s live period, investors can subscribe to it and specify the amount they wish to invest. Successful bidders have the IPO shares credited to their demat accounts.

The IPO remains open for a set period, typically between 3 to 21 days, during which participating entities can submit bids for shares. The allocation of shares may occur through a fixed price or a book-building system, where the final price is determined based on market demand.

What Happens After the IPO

Once shares are allocated to buyers, the company becomes publicly traded on the stock market. Daily trading in the company’s shares takes place in accordance with the market’s rules and regulations. The share price may fluctuate depending on market demand, and some investors, both retail and institutional, may choose to sell their IPO-acquired shares on the first day of trading. This initial surge in supply can lead to a subsequent drop in stock price.

The term “float” refers to the amount of shares available for public trading. The company must adhere to financial disclosure requirements, conduct audits, and provide necessary information as mandated by SEBI after becoming a publicly traded entity.

Basic Terminology

Here are some key terms related to IPOs that you should be familiar with:

• Primary Market: The market where shares are initially offered in the IPO, and the capital raised goes directly to the company.
• Secondary Market: The market where day-to-day trading of shares takes place among the public, without contributing to the company’s capital.
• Red Herring Prospectus: A public document released by the company to solicit bids for the IPO.
• Equity IPO: When shares of the company are offered in the IPO.
• Bond/Debt IPO: When bonds or debt securities are sold in the IPO to raise capital.
• Underwriter: The institution responsible for overseeing the IPO process on behalf of the company.
• Qualified Institutional Buyers: Financial organizations with expertise and financial capacity that participate in bidding for IPOs.
• Oversubscription: A situation where the number of bids exceeds the available shares, often seen with highly anticipated and hyped IPOs.
• Issue Price: The price set for one share of the company being traded.
• Float: The quantity of shares in circulation, owned by the public.
• Flipping: The practice of selling IPO-acquired shares on the first day of trading.
• Secondary Offering: The issuance of new stock to the public after the initial IPO.

When considering investing in an IPO, it’s crucial to make informed decisions based on a realistic assessment of the company’s prospects. Many brokerages and banks now offer online IPO bidding services to retail investors, making it more accessible for individuals to participate in IPOs. Additional information and guidance can be obtained from reputable sources or financial institutions offering these services.

Background Checks

When considering an investment in an IPO, especially in the case of a newly public company with limited historical data, it’s essential to conduct thorough background checks and due diligence to make an informed decision. Here are some key steps to consider:

1. Review the Red Herring Prospectus:

• The red herring prospectus is a vital source of information for potential investors. It provides details about the company’s financials, business model, risk factors, and use of proceeds from the IPO. Scrutinize this document carefully to gain insights into the company’s operations and plans.

• Examine the Fund Management Team:

• Understand the background and experience of the company’s management team, including the CEO, CFO, and other key executives. Assess their track record in managing similar businesses or their expertise in the industry.

• Assess Fund Utilization Plans:

• Pay close attention to how the company intends to use the funds raised through the IPO. Look for a clear and well-defined plan for utilizing the capital to drive growth and achieve strategic objectives.

• Industry and Market Research:

• Conduct research on the industry in which the company operates. Understand the market dynamics, competition, and growth potential. Analyze how the company’s products or services fit into the broader market landscape.

• Competitive Landscape:

• Identify the company’s competitors and assess its competitive advantages or challenges. Consider factors like market share, pricing power, and innovation.

• Financial Analysis:

• Review the company’s financial statements, including revenue, profit margins, and cash flow. Look for trends in financial performance and assess the company’s ability to generate profits and manage debt.

• Risks and Challenges:

• Carefully evaluate the risk factors mentioned in the red herring prospectus. Consider factors such as regulatory risks, market volatility, competition, and operational challenges.

• Corporate Governance:

• Assess the company’s corporate governance practices, including board composition and adherence to ethical standards. Strong corporate governance can be an indicator of a well-managed company.

• Legal and Regulatory Compliance:

• Verify that the company complies with all relevant laws and regulations. Check for any pending or historical legal issues that could affect its operations or reputation.

Remember that investing in IPOs carries inherent risks, and there are no guarantees of returns. It’s crucial to approach IPO investments with caution, conduct thorough research, and make informed decisions based on the available information and your own financial goals.

Underwriting in the context of IPOs and securities issuance refers to the process by which financial institutions or underwriters guarantee the sale of a company’s newly issued shares to investors. Underwriters play a crucial role in helping companies go public and raise capital by taking on the risk of purchasing the shares from the company and then selling them to the public or institutional investors.

Here are some key points about underwriting:

1. Role of Underwriters: Underwriters act as intermediaries between the issuing company and investors. They assess the company’s financials, evaluate its business model, and help determine the appropriate price and terms for the IPO.
2. Risk Mitigation: By underwriting the shares, underwriters assume the risk that they may not be able to sell all the shares to investors. To mitigate this risk, they often form a syndicate of financial institutions to distribute the shares to a broader investor base.
3. Types of Underwriting:

• Firm Commitment Underwriting: In this type of underwriting, the underwriter commits to purchasing all the shares from the company, even if they cannot find buyers in the market. They then sell the shares to investors at the IPO price.
  • Best Efforts Underwriting: Under this arrangement, the underwriter agrees to make their best effort to sell the shares but does not guarantee the purchase of all unsold shares. The company bears more risk in this scenario.

• Underwriting Fees: Companies pay underwriters a fee for their services. This fee is typically a percentage of the total funds raised through the IPO.
• Selection of Underwriters: The choice of underwriters is an important decision for companies going public. Large, reputable brokerage firms with established investor networks and strong research capabilities are often preferred for IPOs with significant success potential.
• Research and Marketing: Underwriters play a critical role in marketing the IPO to potential investors. They often release research reports and conduct roadshows to generate interest among institutional investors and retail investors.
• Small Investment Banks: While small investment banks may underwrite IPOs, as you mentioned, investors should exercise caution. Smaller firms may be more willing to underwrite companies that are riskier or have limited track records. It’s essential for investors to conduct due diligence not only on the issuing company but also on the underwriters involved.
• Due Diligence: Investors should research the underwriters involved in an IPO, their reputation, track record, and experience in handling similar offerings. The underwriting team’s expertise can influence the success of the IPO.

Underwriters play a critical role in the IPO process, helping companies raise capital and navigate the complexities of going public. When considering an IPO investment, it’s important to assess the underwriters’ capabilities, as their reputation and ability to market the offering can impact its success. Large, well-established brokerages are often preferred choices for companies with a strong IPO potential.

In the world of Initial Public Offerings (IPOs), various types of bidders and bidding methods come into play, each with its unique characteristics. Here’s a breakdown of the types of bidders and the bidding methods commonly associated with IPOs:

Types of Bidders:

1. Retail Investors: These are individual investors like you and me who participate in an IPO. Retail investors typically invest smaller amounts of capital compared to institutional investors. They do not need to meet specific criteria or qualifications to participate.
2. Non-Qualified Institutional Investors (Non-QII): This category includes a diverse range of entities, such as corporates, trusts, societies, and non-resident Indians (NRIs). Non-QII investors do not qualify as institutional investors under SEBI guidelines.
3. Qualified Institutional Investors (QII): QII is a category of investors that includes financial institutions and entities that meet specific criteria set by SEBI. These institutions often have significant financial resources and expertise in investment. QII includes:

• Financial Institutions: Such as banks and insurance companies.
  • Brokerages: Firms engaged in brokerage and trading activities.
  • Foreign Institutional Investors (FII): Overseas entities investing in Indian securities markets.

Not all IPOs are open to retail investors; some are exclusively available for institutional investors.

Types of Bidding Methods:

1. Issue Price: The issue price is the initial price at which one share of the company is offered to investors during the IPO. There are two primary pricing options involved:

• Fixed Price: In a fixed price IPO, the price per share is determined and announced by the company before the IPO opens for subscription. Investors know the exact price they will pay for each share when they apply for the IPO.
  • Book Building: In a book-building IPO, the price per share is not fixed before the IPO opens. Instead, it is determined through a dynamic process during the subscription period. Investors submit bids specifying the quantity they wish to purchase and the price they are willing to pay. The final issue price is determined based on the demand for shares at various price levels. This method allows for greater price discovery and can result in a more accurate reflection of market demand.

• Float: The term “float” refers to the portion of a company’s shares that are made available to the public through the IPO. Not all of the company’s shares are listed on the market during the IPO; typically, only a small proportion is made available for trading on stock exchanges. The float represents the shares that are actively traded by investors in the secondary market after the IPO.

Once you have grasped the fundamental concepts of the types of bidders and bidding methods in an IPO, you can delve deeper into the practical aspects of subscribing to an IPO. Participating in an IPO involves understanding the company’s financials, evaluating its prospects, and making informed decisions based on your investment goals and risk tolerance. Keep in mind that IPOs can be an attractive investment opportunity, but they also carry risks, so thorough research and due diligence are essential before participating in one.

How to Invest in IPO in India

Subscribing to an IPO involves several steps, and it’s essential to follow the process carefully to ensure a successful application. Here’s a simplified guide on how to subscribe to an IPO:

1. Check Eligibility: Verify if the IPO is open to retail investors. Not all IPOs are available to individual retail investors; some may be reserved for institutional or specific investor categories.
2. Prepare Your Demat Account:

• Ensure you have an active and funded demat account. To subscribe to an IPO, you must have a demat account in your name.
  • Locate your 16-digit DP-ID (Depository Participant Identification) number. This number comprises two parts: the first 8 digits represent your broker, and the last 8 digits form your client ID. This information is crucial for linking your demat account to the IPO application.

• Access Your Internet Banking Portal:

• Log in to your internet banking portal using your credentials.
  • Navigate to the IPO section. The specific location of this section may vary depending on your bank’s website or app. Look for options related to “Investment” or “IPOs.”

• Select the IPO:

• Browse and select the company whose IPO you wish to subscribe to. You will typically find a list of available IPOs with details such as the company’s name, IPO opening and closing dates, and issue price.
  • Click on the desired IPO to initiate your application.

• Enter DP-ID:

• You will be prompted to enter your 16-digit DP-ID. Ensure that you enter this information accurately, as it links your IPO application to your demat account.

• Provide Required Information:

• Follow the on-screen instructions to provide necessary details, including the number of shares you want to apply for and the price you are willing to pay per share. If it’s a book-building IPO, you may need to specify a price within the price band determined by the company.

• Payment:

• Complete the payment for your IPO application using the available payment options on the banking portal. Payments are typically made through your linked bank account.

• Check and Confirm:

• Review all the information you have provided to ensure accuracy.
  • Confirm your IPO application.

• Wait for Allotment:

• After the IPO subscription period closes, the company and the registrar to the issue will process the applications.
  • If your application is successful, and you are allotted shares, they will be credited to your demat account.

1. Monitor Your Demat Account:
2. Keep an eye on your demat account to see if the shares have been credited to your account.
3. You can also check the IPO allotment status on the official website of the IPO registrar or through your bank’s IPO portal.

It’s important to note that the process may vary slightly depending on your bank or broker’s specific online IPO application system. Additionally, it’s crucial to perform due diligence on the IPO, research the company, and assess your investment goals and risk tolerance before applying for shares. IPOs can be competitive, so it’s a good idea to apply early during the subscription period.

Relationship Between Market trends and IPO Performance

Market trends and the performance of IPOs are indeed interconnected, and the success of an IPO can be influenced by the overall market conditions. Here are some key points to consider regarding the relationship between market trends and IPO performance:

1. Market Trends Influence IPOs:

• IPOs are often influenced by the prevailing market conditions. In a bullish or favorable market trend, where stock prices are generally rising, IPOs tend to perform better. Investors are more willing to participate in IPOs during such periods, increasing demand for new shares.

• IPOs Reflect Market Sentiment:

• IPOs can serve as a barometer of market sentiment. When IPO activity is robust, it can signal confidence in the economy and the financial markets. Conversely, a lack of IPO activity or a weak IPO market can indicate caution or pessimism among investors.

• Strong IPOs in Bull Markets:

• IPOs of companies with strong fundamentals are more likely to succeed in bullish market trends. Investors are often attracted to companies with growth potential and solid financials during these periods.

• Market Leadership vs. IPO Leadership:

• While IPOs can follow the broader market trends, they may not necessarily lead them. Established companies and market indices often set the tone for market movements, and IPOs react to these trends.

• Risk and Reward in IPOs:

• Participating in IPOs can offer the potential for significant gains, but it also carries risks. IPOs can be volatile, and their performance may not always align with broader market trends. It’s essential for investors to conduct thorough research and due diligence before investing in any IPO.

• No Guarantee of Returns:

• It’s important to note that investing in an IPO, even in a bullish market, does not guarantee quick or substantial returns. Market dynamics, company-specific factors, and the timing of your investment can all impact the outcome. There are cases where IPOs perform poorly despite favorable market conditions.

• Investor Responsibility:

• Investors bear the responsibility for their investment decisions. Companies going public are not obligated to return your money if the stock performs poorly. Success in IPO investing depends on factors like the company’s fundamentals, industry dynamics, and overall market conditions.

In summary, while market trends can influence IPO performance, there are no absolute guarantees in the stock market. Investing in IPOs should be approached with careful consideration of the specific company’s prospects and the broader economic environment. Diversifying your investment portfolio and conducting thorough research are prudent strategies to manage risk and potentially capitalize on opportunities in IPO investing.