What is an IPO and How it Works in the Stock Market?

There is hardly any doubt in the fact the every business, whether big or small, national or international, needs funds to run smoothly. Though there are several ways of obtaining funds not just for business incorporation but for business functioning too. One of the most popular ways these days is to raise an IPO in the stock market. Put simply, the IPO of a company in listed in the stock market for two purposes. The first goal is to raise capital from the public by listing its shares for sale. Second, it gives an opportunity to stock traders to become part owners in the business. For those looking to main gains on their investments, investing in IPO is a great and proven strategy. Here we have come up with a post that would cover every single thing about IPO that you would love to know. So, let’s start and delve deep into the world of IPO and its associated elements.

What is an Initial Public Offering ( IPO)?

IPO stands for Initial Public Offering. It is when a company decides to go public with a purpose to raise funds for any underling purpose such as expanding business. Since company’s shares are offered to public, a huge amount of fund is accumulated by the company. One major feature of IPO is increased transparency and stock listing that help companies settle on improved terms when attempting to get borrowed amount.

However, one crucial thing to note is that not every companies is entitled to go public and raise its IPO in the stock market. There are rigorous guidelines stated by the Reserve Bank of India (RBI) in regarding to listing of an IPO. So, only a few businesses can choose to list their IPOs particularly the businesses that have reached a stage where they can easily meet RBI’s guidelines with respect to IPOs. This is only the public would be interesting in buying the shares of a company through IPO launch. You can take examples of Paytm, Zomato, etc.

In recent times, this kind of stage is realized when the business has attained a unicorn status. In monetary terms, a company is considered unicorn when it attains a separate worth of $1 billion.

Launching an IPO is a big-big decision for a company’s management and it gives the company a direct entry in the stock market along with an unprecedented exposure to the public. So, it has been observed that only substantial firms have been able to raise funds by launching an IPO in the stock market.

After the company turns public, it becomes possible for stock investors to buy its shares from the stock exchange. The buyers become the part owners of the firm after investing in the company’s shares. In entitles them to receive dividends and also the losses faced by the company.

In the case of IPO launch, the company decides to put its shares on sale to both individual and institutional investors. Retail investors generally have limited capital and they purchase lesser no. of shares. On the other hands, institutional investors may choose to buy a large number of shares. Some examples of hedge funds, mutual funds, and insurance firms.

How does an IPO work?

Once a company decides to launch an IPO, it is obliged to follow a set of instructions stated by SEBI. Among several steps, the first is to choose a merchant banker, also called Book Running Lead Manager (BRLM)/Lead Manager (LM). The primary responsibility of a merchant banker is to help the company across several elements of the IPO process, like:

• Perform due diligence on the business applying for an IPO, safeguarding their legal acquiescence and delivering a due diligence certificate.
• Work in the close coordination with the business and draft their listing papers, including Draft Red Herring Prospectus (DRHP).
• Underwrite shares – Underwriting shares mean when merchant bankers fundamentally decide to buy all or part of the IPO shares and re-sell the same to the public.
• Assist the business choose the most appropriate price band for the IPO. A price band has the lower and upper limit of the share price at which the company will go public.
• Helps in business promotion by planning various promotional/marketing activities related to a company’s IPO.
• Selection of other mediators, particularly bankers, registrars, and advertising firms. The Lead managers are also engaged in various marketing strategies for the issue.

The first and foremost task of a merchant banker is to help the business at every step of its IPO launch.

How an IPO is Launched ,Step-wise IPO Listing Procedure

If you want to know the procedure of how to launch an IPO, below is a step-by-step guide on how to do it.

Step 1: Selection of A Merchant Banker

These experts provide all sorts of support when it comes to continuing the IPO process. They serve as mediators between the company launching an IPO and the stock traders and investors.

Step 2: IPO Registration

First things first, a draft of the registration statement and prospectus will be prepared by the merchant banker. It is also called red herring prospectus (RHP) and holds immense value for use to a retail investor for offer checking. It contains all the information about the company except the no. of offered shares or stocks. It is mandatory for all companies that are planning to launch an IPO to submit the red herring prospectus.

According to the information available in the Section 32 of the Companies Act:

• The business looking to launch an IPO files the Red Herring Prospectus to the Registrar of Companies 3 days prior to the release of the IPO to the public.
• The RHP must contain all the conditions that are there in the company’s prospectus. All the differences need to be highlighted and approved by ROC and SEBI.  
• After the closing of the IPO bidding, a final version of the prospectus needs to be submitted to both SEBI and ROC. It should carry details like the quantum of shares being released and the eventual sale price.
• The Red Herring Prospectus is used for the marketing of the IPO by the underwriters and the issuer. It is of immense worth for a retail investor who can refer to this doc to know more about the company and the IPO offer. It contains all the crucial details that are made mandatory by the SEBI. It contains things like:

Descriptions: All prominent concerns and industry related keywords are explained in this portion. If an investor analyses an offer from a commercial sector he is familiar with, this section may not be much value to him or her.

Risk Factors: This part reveals every possibility that could leave a physical impact on the business’s performance after its IPO listing, and the share price.

Use of Proceeds: This is undoubtedly the most critical part of the RHP. This is intended to provide the investors with the details about the utilization of the funds raised through the IPO listing. This clearly indicates the growth direction of the business, and the ways company’s finances are handled.

Industry Explanation: This segment delivers forecasts and calculations about the bigger industry the company belongs to.

Business Explanation: As its name indicates, this section highlights all the major activities done by the company looking to list its IPO.  It also reveal the profit generating roadmap of the company which means it is extremely valuable to investors who may choose to invest in company’s shares.

Management: This section contains information on the directors, promoters, and important members of the management team. Investing in a new business is essentially investing in the skill of the management group. As a result, investors carefully study this part and try to learn as much as they can about the individuals who founded the business.

Financial Details: This portion details auditor’s reports and the financial records of the company for the last 5 years.

Legal and Other Information: All litigations snaked against the business or its promoter or a director which are still pending are highlighted in this section.

Step 3: Cooling-off period

At this moment, SEBI confirms the facts revealed by the company. It searches mistakes, blunders, and inconsistencies. Only after getting the SEBI’s approval, a date will be allotted for the IPO listing.

Step 4: Stock exchange application

The company submits an application with the stock exchange and informs the authority about its plans to release the IPO.

Step 5: Spread the word

At this time, the company plans and releases a few advertisements about the upcoming launch of its IPO offer through various channels both digital and conventional. There could be numerous ways adopted by a company and investment banker to spread the word about the IPO. The idea is to promote it on a bigger platform so as to persuade the general public to buy the IPO.

When a business chooses to turn public, it hires one ore more bankers or underwriters for the listing job.

After obtaining the necessary approval from SEBI, the date for floating the IPO is announced.

Right after, a RHP is discharged.

Then, the investment bankers, underwriters, and company management plan out the marketing activities.

The Process

The prospective investors are persuaded of the company’s potential through road shows. They emphasise the anticipated market share as well as the company’s direction for future growth. Fund managers and business analysts also have meetings with the road show crews. These experts could provide perceptions that improve the business’s initial public offering procedure.

Executives from the company employ interactive presentations, Q&A sessions, and other easily navigable methods to give every information regarding the first public offering. Businesses are increasingly publishing road show versions online for everyone to view. Companies may also schedule meetings for small groups of investors a few days or weeks before to the IPO in order to assist them.

Step 6 : IPO Procedure

There are two types of IPO procedures. They are:

(A) Fixed price issue

(B) Book building issue

In the case of fixed price issue, the sales price of the shared that are known to be allotted is declared to the investors in advance. On the other side, in a book building issue, the issuer proposes a 20% band for share price within which investors can bid. Once the bidding process is over, the final price is determined. This 20% band is known as an IPO price band.

The retail and institutional buyers are asked to make their bids within this band. The book containing the gathering of bids for the IPO remains accessible to all investors. It also means that the demand for the shares offered at different prices is open to all existing and probable investors. It is necessary to note that the bid price can’t be lower than the IPO floor price, which means the lower threshold of the price range. It also cannot exceed the upper bound of the band, which is the IPO cap price.

Bidders may amend their offers for the duration that the book is open, which is typically three days. Because the book building process allows issuers to learn about pricing and demand, they prefer it over fixed price issues. By doing this, the issuer may make sure that the offering creates as much value as the market will bear. The cut-off price is the amount at which the issue is ultimately sold. The maximum price at which all of the shares up for sale can be sold is this.

Step 7: IPO Listing

It is the eventual step before the launch of the IPO. One interesting thing to remember that companies ensure that internal investors don’t get the opportunity to trade in the listing IPO. There is several reasons behind this.

• It helps in the stabilization of the market without including extra selling pressure from internal investors.
• It averts unethical people from hocking off overpriced shares against typical buyers.
• It defends retail investors from a wrought offer price of the stocks.
• It prevents the stock market from being encountered with an excessive number of shares that may hamper the usual demand–supply balance.

Trending topic : Role of Stock Exchange Board of India (SEBI) in Stock Market

Step 8: Sale of Shares

At the end, the issues are sold to the investors on the primary market and the funds are accumulated. The bidding period lasts for almost 5 days.

Step 9: Share Allocation

The allocation of the company’s shares will be done bidders within 10 days from its last date. If the IPO faces oversubscription, the allocation of the shares are done proportionally to the bidders.

Advantages and Disadvantages of an IPO

Though there could be numerous perks association with an IPO listing in the stock market, it also tends to have several downsides. Hence, listing an IPO may not be a wise decision for every business. Therefore, a company must need to take into account all the advantages and disadvantages associated with the launch of IPO before going in that direction.

Fundraising: Raising funds is one of the clear and well-noted advantages of listing an initial public offering. This funs can be used for several things like R&D, new talent hiring, consolidating debt, or the purchase of new machinery, office etc.

Exit Opportunity: There are stakeholders in every business who have put in considerable amounts of time, money, and resources with a goal to set the ground for a fabulous company. These founders and investors continue their efforts without getting any noteworthy monetary payback. An IPO is considered a wonderful exit opportunity for these stakeholders to sell their shares and cash in their ROI.

Publicity and Credibility: If a company decides to launch its IPO, it will get augmented exposure to possible clients/customers who will buy its products or services.

Reduced Overall Cost Of Capital: A major obstacle for any company, especially younger private companies, is their cost of capital. Before an IPO, companies often have to pay higher interest rates to receive loans from banks or give up ownership to receive funds from investors. An IPO can ease the challenges of receiving additional capital significantly, as the company itself needs to go through stringent audits before going public.

However, any company going public must also consider its potential drawbacks.

Additional Regulatory Requirements And Disclosures: Unlike private companies, public companies must file their financial statements with the SEBI annually. These regulations are both difficult and costly.

Market Pressures: Market pressures can be very difficult for company leaders  who are used to doing what they feel is best for the company. Founders tend to have a long-term view, whereas the equity market has a very short-term, profit-driven view.

Potential Loss Of Control: One major disadvantage of an IPO is founders may lose control of their company. While there are ways to ensure founders retain the majority of the decision-making power in the company, once a company is public, the leadership must keep the public happy, even if other shareholders do not have voting power.

Transaction Costs: IPOs are expensive. Beyond the recurring expenses of public company regulatory compliance, the IPO transaction process comes at a hefty cost. The highest cost of a public offering is underwriter fees. Underwriters typically charge between five per cent and seven per cent of the gross proceeds.

Conclusion

An initial public offering may or may not be the right direction for a company. IPOs come with many advantages and disadvantages for the company and investors. Both entities need to determine if their requirements are fulfilled via the IPO. In the past, several public companies had to take a U-turn by going private. Ideally, no public company would want to reach this stage. Hence, you must patiently weigh all factors before making a final decision.

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