An Initial Public Offering (IPO) refers to the process where a private company offers its shares to the public for the first time. This allows the company to raise capital from public investors by selling a portion of its ownership. IPOs are often a significant milestone in a company’s life cycle, marking its transition from a privately-owned business to a publicly-traded entity.
Let’s break down the key aspects of an IPO: its meaning, types, the process, and eligibility requirements.
Meaning of IPO
An IPO is a way for companies to generate funds by issuing shares to institutional and retail investors. It can also serve as an opportunity for early investors to exit their holdings in the company, converting their stakes into public equity. Companies usually go public to expand operations, pay off debts, or raise capital for future ventures.
By becoming publicly traded, a company is also subject to stringent regulations and disclosures set by the stock exchanges and the market regulators, like the Securities and Exchange Board of India (SEBI) in India or the Securities and Exchange Commission (SEC) in the United States.
Types of IPOs
There are two main types of IPOs:
- Fixed Price Offering: In a fixed-price IPO, the company sets a predetermined price for its shares before going public. Investors must decide whether they want to purchase shares at this price.
- Book Building Offering: In this type, the price is not fixed but determined by investor demand. The company sets a price band, and investors place bids within this range. Based on these bids, the final issue price is determined. This method is more popular as it offers flexibility in price discovery.
Process of IPO
Launching an IPO is a lengthy and complex process that typically involves the following steps:
- Hiring Underwriters: The company appoints an underwriter, typically an investment bank, to manage the IPO. The underwriter helps determine the price, the timing of the offering, and the number of shares to be issued.
- Due Diligence and Regulatory Filings: The company must prepare and submit necessary documents like the Draft Red Herring Prospectus (DRHP) in India or the S-1 form in the U.S. These documents provide detailed information about the company’s financials, business model, risks, and objectives of the IPO.
- Setting the Price Band: In a book-building IPO, the company sets a price band. Investors can place bids within this price range during the offering.
- Marketing and Roadshows: The company promotes the IPO to institutional investors through roadshows, where management meets with potential investors to generate interest and demand.
- IPO Subscription: During the subscription period, investors place orders to buy shares. Once the bidding process closes, the underwriter determines the final price based on the bids received.
- Allocation of Shares: After the price is set, shares are allocated to investors. Institutional investors usually receive a larger portion, while the rest is allocated to retail investors.
- Listing on the Stock Exchange: After the shares are allocated, the company is listed on a stock exchange, allowing shares to be bought and sold by the public. The first day of trading, known as the listing day, is often marked by volatility as investors adjust to the public market price.
Eligibility for IPO
For a company to launch an IPO, it must meet certain criteria laid down by regulatory authorities:
- Financial Stability: The company should have a track record of profitability or consistent growth over a period. In India, SEBI requires the company to have a minimum net worth and net tangible assets, among other financial prerequisites.
- Compliance with Regulations: The company must comply with legal, financial, and corporate governance norms. These include proper auditing of financial statements, regular board meetings, and filing necessary documents with the stock exchange and regulatory bodies.
- Market Standing: The company should have a strong reputation and market standing, which helps build investor confidence.
- Age of the Company: While not a universal rule, many markets require the company to have been operational for a certain number of years before going public.
Terms Associated with IPO
To gain a comprehensive understanding of IPOs, it’s essential to familiarize yourself with some key terms related to the process. Below are some commonly used terms:
| Terms | Descriptions |
|---|---|
| Issuer | An issuer refers to the company or firm that seeks to sell shares in the secondary market to finance its operations. |
| Underwriter | An underwriter can be a banker, financial institution, merchant banker, or broker that assists the company in underwriting its stocks. Underwriters also agree to purchase any remaining shares if the stocks offered in the IPO are not fully subscribed by investors. |
| Fixed Price IPO | A Fixed Price IPO refers to the specific price set by a company for the initial sale of its shares. |
| Price Band | A price band is a method of setting a price range, specifying an upper and lower limit within which interested buyers can place their bids. This range serves as a guideline for buyers. |
| Draft Red Herring Prospectus (DRHP) | The DRHP is a document that informs the public about the company’s IPO listings after receiving approval from SEBI. |
| Under Subscription | Under subscription occurs when the number of securities applied for is less than the number of shares available to the public. |
| Oversubscription | Oversubscription happens when the number of shares applied for exceeds the number of shares offered to the public. |
| Green Shoe Option | This refers to an over-allotment option, which is an underwriting agreement that allows the underwriter to sell more shares than initially planned if the demand for the shares is higher than anticipated. |
| Book Building | Book building is the process through which an underwriter or merchant banker determines the price at which the IPO will be offered. The underwriter compiles a book of bids from institutional investors and fund managers, detailing the number of shares they wish to purchase and the prices they are willing to pay. |
| Flipping | Flipping is the practice of reselling an IPO stock shortly after its debut to realize a quick profit. |
Conclusion
An IPO is an essential tool for companies to raise capital and expand their operations. While it provides access to public funds and increased visibility, it also comes with greater scrutiny, accountability, and compliance obligations. Understanding the types, process, and eligibility criteria can help investors make informed decisions when considering investing in an IPO.
FAQs About IPOs
What do you mean by IPO?
An IPO, or Initial Public Offering, is the process through which a private company offers its shares to the public for the first time, transitioning into a publicly traded entity. This allows the company to raise capital from public investors.
How does an IPO work?
An IPO works by having a company partner with underwriters to determine the share price and the number of shares to be issued. The company files necessary documentation with regulatory authorities, promotes the offering to potential investors, and once the shares are sold, they become publicly traded on a stock exchange.
Is IPO profitable?
IPOs can be profitable, but their success depends on various factors, including market conditions, the company’s performance, and investor demand. While some IPOs may generate quick profits for investors, others may not perform as well over time.
Is an IPO a good investment?
Whether an IPO is a good investment depends on individual circumstances, including the company’s fundamentals, industry trends, and market sentiment. Investors should conduct thorough research and consider their risk tolerance before investing in an IPO.
How to sell IPO shares?
To sell IPO shares, you need to have a brokerage account. Once the shares are listed on the stock exchange, you can place a sell order through your broker. The shares will be sold at the current market price, and you will receive the proceeds in your brokerage account.
