IPO basics

An IPO is a fundamental part of our economy and lives, one that’s hard to notice, yet integral. IPO stands for Initial Public Offering, and means just that - a company offering itself (or its shares) to the public. All the major companies that dominate our economic landscape today attained their positions from wealth created via IPOs. For individuals too - if you’re looking to make the best investment choices to grow your wealth, an Initial Public Offering (IPO) can offer a lucrative opportunity provided one has a working knowledge of IPOs. This article looks at all the basics of an IPO you need to know before you start investing in one.

Key Points

  • IPO stands for Initial Public Offering. As the term suggests, it happens when a company “offers” itself (or its shares) to the public.
  • In an IPO, a private company offers new shares to the public in exchange for capital. This capital is then used by the company for growth.
  • An IPO approval is granted by a regulatory authority. In India, it is the Securities and Exchange Board of India (SEBI).

How does company ownership work?

Before deciphering an IPO, it is important to understand how a particular company is owned. A company, in the traditional definition of the term - is an organization comprised of assets which include capital, infrastructure and people. A company buys inputs such as raw materials and labour, rents/buys infrastructure to produce outputs in the form of goods and services.

Companies can either be:

  • Privately owned
  • Publicly owned and traded

Private ownership of a company implies it is totally funded by one or many private entities. A publicly owned company is one which is at least partly funded by the public and traded on share markets. A person or an institution that funds a company is part owner of the company and is allotted shares of the company, bestowing voting rights on the shareholder. So a company may be fully owned by a single entity or multiple entities may own the company as part owners.

The Company appoints a board of directors based on the majority vote of the shareholders. The board of directors is empowered to make decisions on behalf of the company.

Now​ ​that​ ​you’ve got​ ​a​ ​cursory​ ​idea​ ​of​ ​how​ ​companies​ ​are​ ​owned,​ ​let’s​ ​look​ ​at​ ​what  an IPO​ ​is​ ​and​ ​how​ ​it​ ​works.

What is an IPO?

An Initial Public Offering is the first offer of shares made by a private company to the general public. In an IPO, the private company offers new shares to the public in exchange for capital. This capital is then used by the company for growth. IPOs are therefore a valuable tool for rapidly expanding companies in need of capital and an opportunity for the public to profit from holding shares of profitable companies.

The majority stake of private owners (founders and promoters) is diluted after the company's IPO is released. Their voting powers and influence also dwindles. However, that depends on how existing officers lead the company into its chapter as an IPO. An IPO​ ​is​ ​a​ ​powerful​ ​tool​ ​to​ ​rapidly​ ​raise​ ​capital​​​ ​in​ ​a​ ​company’s​ ​pursuit​ ​of​ ​growth, since the shares are being sold for money.

Quiz: Which of these companies held the biggest IPO in India?

Options: A - Reliance Power, B - DLF, C - Coal India, D - HCL

*Answer: Coal India delivered India’s biggest IPO, raising Rs 15,200 crores via 63 shares. The IPO was subscribed over 14 times. Reliance Power’s IPO generated Rs 11,000 crores, while DLF raised Rs 9,000+ crores

How an IPO works

A company works tirelessly to ensure that it gets an approval to file an IPO. As it is with starting a new business, so is the case with filing for an IPO. Definitely not a cakewalk. An IPO approval is granted by a regulatory authority. In India, it is the Securities and Exchange Board of India (SEBI).

Before an IPO can be approved, it must undergo a long and arduous scrutiny by the regulatory authority to determine eligibility for filing an IPO. Some of the steps involved are:

  1. Filing of application with SEBI with all relevant details including the number of shares to be issued, the price set (in case of a fixed price IPO), previous records of the company, proposed use for the funds to be raised etc.
  2. After getting approval from SEBI, the company issues what is called a red herring prospectus- this contains information on its past records and details about the IPO.
  3. The company contracts a lead manager to manage the sale of the IPO, which may be an investment bank or brokerage.
  4. The lead manager then solicits bids for the IPO from investors, mostly financial institutions and in some cases, retail investors.
  5. When the IPO goes live, investors can subscribe to it and specify the amount they’d like to invest. If they’re successful, the shares are credited to the bidder’s demat account.

The IPO is open for a period of 3-21 days during which participating entities can offer bids for shares. Shares may be allotted based on a fixed price or by the building book system where price is fixed after gauging market demand. Fixed price for an IPO is determined based on the amount of bids at different price points.

What happens after the IPO

After shares are allocated to the buyers, the company is listed as a publicly traded stock in a share market. Trade on the shares takes place daily, in accordance with the share market’s rules and regulations. Depending on the market’s demand, the share may be traded at a price higher or lower than the IPO price. Some retail or institutional investors may sell off stocks acquired from the IPO on the first day of trading. This may lead to a fall in stock price later on, due to excessive supply.

The amount of stock in circulation is called float. The company has to make financial disclosures, audit its accounts and release all necessary information as mandated by the SEBI after it becomes a publicly traded company.

Basic terminology

When it comes to IPOs, the following are some of the technical terms (jargon) used that you might want to be familiar with:

  • Primary market - Shares offered in the IPO. Capital goes to the company’s coffers which is used by the company for stated purposes.
  • Secondary market- Day to day trading on the share market between public entities. Doesn’t add to company’s capital since this is between individual sellers and buyers - this is what you’re likely to be dealing with on platforms like Upstox Pro.
  • Red herring prospectus - A public document published by the company seeking bids for IPO.
  • Equity IPO - If equity is offered in the IPO.
  • Bond/Debt IPO - If it is bond/debt that is sold in the IPO to raise capital.
  • Underwriter - The institution in charge of conducting the IPO proceedings at the behest of the company.
  • Qualified institutional buyers - Financial organizations with expertise and financial muscle which bid on IPOs.
  • Oversubscription - A situation where the number of bids outstrip the amount of shares offered. This is common with popular and hyped companies.
  • Issue price - Price fixed for one share of the traded company.
  • Float- Amount of shares in circulation, that is, amount held by the public.
  • Flipping - Selling shares bought in the IPO on the first day of trade.
  • Secondary offering - New stock offered later on to the public after the IPO.

A decision to invest in an IPO must be financially sound and based on a realistic assessment of the company’s prospects. Many brokerages and banks now provide e-IPO facilities to retail investors where IPO shares can be bid upon online. For more information, you can search online or get in touch with institutions offering services.

Wrapping Up

  • IPOs are a fundamental part of our economy, and help propel many major companies to large growth and market capitalisation.
  • A privately held company may offer its shares to the public to raise funds. This is done via an Initial Public Offering - an IPO.
  • An approval from SEBI, along with adherence to rules and regulations is mandatory for an IPO to proceed.
  • Investors and traders can then subscribe to an IPO when it goes live.