What is an IPO?

29 Dec 2020  Read 836 Views

If you have been following the stock market this year, you probably would have encountered the term IPO a lot. For regular investors, this term is quite common and yet, each time it comes up, it brings a spark of excitement with it.

If you are a beginner to the stock market, you might wonder why that is; why each time an IPO is announced, it is all the finance media can talk about, and why does the investor circle get all pumped up during some IPOs?

In the last few months, you might have noticed that IPOs like Burger King, Rossari Biotech and others have given more than 100% return in the first week of listing.

So, coming back to the major question here: What is an IPO and What is all the hype about?

Let’s get into it.

Initial Public Offering: Definition

An IPO (Initial Public Offering) is the process through which a private company goes public by offering its stock to the general public. The company raises capital by publicly issuing its shares.

The company that offers its shares is referred to as an “issuer”. The issuer offers its shares with the help of an investment bank. After IPO, the shares of the company are traded in the open market. 

Why do companies go public?

  • To raise capital: An IPO brings immediate cash from the stock sales for a company, its promoters, and for investors like angel investors and venture capitalists.
  • Long-term benefits: A publicly-traded company can make an all-stock or cash and stock bid for another company it wants to acquire, instead of an all-cash bid which may require heavy borrowing. Stock and options are considered as a much more valuation incentive compensation, which allows a public company to attract and retain talents in the firm.
  • Cachet: An IPO brings prestige to a company. A listed company is regarded as more reliable to counterparts, to lenders, and investors.

What IPOs mean to the Economy?

The number of IPOs being issued can also be suggestive of the health of the stock market and the Economy.

During a recession, the listing of IPOs gets dropped because the market price is undervalued. On the other hand, when a huge number of IPO listings happen, it means that the Economy and the market is getting back on track.

                                            

The IPO Process

The IPO process happens in five steps: 

Selecting the Lead Investment Bank

The IPO process starts with the promoters selecting a lead investment bank. This process generally occurs six months before the IPO. The applicant bank submits bids detailing the IPO result and the bank fees. The company selects the investment bank based on its reputation, quality of research and expertise in the market. 

The company wants an investment bank which can sell its shares to a maximum number of banks, institutional investors, or individuals as per the requirement. It’s the investment bank’s responsibility to put together all the buyers. It selects a group of banks and investors to raise IPO funding and also diversifies the risk. 

The investment bank charges a fee between three to seven per cent of the IPO’s total sales price.

This process of an investment bank handing an IPO is known as “underwriting”. Once chosen, the investment bank and company write the underwriting agreement detailing the amount to be raised, the type of securities to be issued and all other fees. 

Due Diligence

The next step of the IPO process is due diligence and regulatory filings. It generally happens three months before the IPO. The IPO team consisting of the lead investment banker, lawyer, and other specialists, prepare the due diligence. The team assembles all the required financial information.

The investment bank files the registration statement with SEBI. This statement includes the financial statement, management background, and any legal problems. It specifies the purpose of the IPO, where the raised money will be used, and the current owners of the company. It also shows the company’s working model and other related factors.

SEBI will then investigate the company. It makes sure all the information disclosed by the company is genuine and is for the interest of the investors.

Pricing

The third and most crucial step of the IPO process is pricing. It depends upon the value of the company and the current situation of the market and the Economy.

After the SEBI’s approval, SEBI and the company set up a date for the IPO. The underwriter circulates the prospectus, which includes all the financial information of the company and shares the prospectus with the potential investors.

The company writes transition contracts for vendors. It also completes the financial statement for submission to auditors.

Almost three months before the IPO, the board of directors meet and review the audit. The company then joins the stock exchange that will list its IPO.

In the final month, the company files its prospectus with the SEBI. It also issues press notes announcing the availability of the shares to the general public.

Generally, on the day of the IPO, the company’s head visits BSE or NSE for the first day of trading and often rings the bell to open the market.

Stabilization

The fourth step of the IPO process is stabilization. It happens just after the IPO. The underwriter creates a market for the stock after it has been issued. It makes sure that there is a good amount of buyers to keep the stock at a reasonable price. It lasts for 25 days which is the “quiet period”.

Transition

The fifth and final stage of the IPO process is the transition to the open market competition. It starts after the quiet period ends. The underwriters provide approximate company’s earnings, which helps the investors as they transition depending upon the public information about the company.

Inside investors are free to sell their sales after six months of the IPO.

Advantages of IPOs

  • An IPO usually suggests that the company is doing well enough to raise more capital to grow more. The raised capital helps in investing in a new project, to acquire new infrastructure and to pay off debt.
  • The shares of a company can also help in merger and acquisitions. The company can offer its shares as a mode of payment for acquiring another business.
  • An IPO helps a company to hire the best-talented people in the management. Additionally, it can hire employees on lower wages by offering shares option during the IPO.
  • The promoter’s investment value increases many folds during the IPO, which pays off their hard work.

Disadvantages of IPOs

  • The IPO process is very costly for the company. The leader of the company gives more attention to the IPO, which may affect the working of the company. Investment banks also charge a hefty fee for their services.
  • Original owners may not be able to sell their shares just after the IPO, as this could reduce the share price of the company.
  • The business control goes to the board of directors, of which the original owner may or may not be a part of. In adverse conditions, the board of directors also have the power to fire the original owner from the company.
  • The company has to work under the strict scrutiny of the SEBI. 
  • A lot of details about the company goes into the public.

                                        

Conclusion

There is a lot of excitement in the market when a company goes public. So, when an IPO occurs, investors tend to get excited with the thought of earning a quick return and make some good amount. It might also happen that the investors may lose their money quickly just after the IPO takes place.

Investing in an IPO involves taking a chance on a firm. Investors may favour it or deem it overvalued.

But a prudent investor will examine the company’s prospectus and management team in detail. This will improve the chance of investors to bid for the best IPO and earn a good amount of money quickly.

About the Author: Harshit Roy | 34 Post(s)

Harshit Roy is a BMS student at St. Xavier's College, Kolkata majoring in finance. He is bibliophile in nature, and quite eager to learn and read about new things in life.

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