IPO (Initial public offering)
Have you been always thinking from where the term IPO emerged? Well, we are here to tell how the IPO process works! The term initial public offering skated into everyday speech during the bull market of the late 1990s.
However, there are various confusing questions that still persist in our mind. Some of these questions are-
- What is an IPO?
- How did everybody get so rich with the early IPO’s?
- Who can come up with the idea of an IPO for the first time?
- What is the process involved in it?
So let’s try to answer all these questions one by one.
What is an IPO?
An initial public offering is the first sale of a company’s stock to the general public. In normal business circumstances a company can raise money by either issuing debt or equity. So if the company has never issued equity to the public and is doing it for the first time, it is known as an IPO.
What are the reasons for Going Public for a Company?
A company’s status shifts from privately held to public, when it registers its securities so that it can offer and sell them.
- Company can go public for raising cash.
- To increase the company’s value.
- It affords higher access to capital.
- Stocks can be used in lieu of cash for acquisitions.
- Stocks can be used as tools to recruit and retain executives and other employees. Stock options can be offered as bonuses and compensation to the employees to increase their motivation.
- Stocks offer liquidity to the companies. It also offers a clear exit strategy for investors.
- Going public affords more reliability and prestige in the business world.
- It helps in creating sharp public exposure and brand awareness.
Getting out of a hot IPO is very difficult. To understand how an IPO is done, let’s understand the process of Underwriting.
- Underwriting is the process of raising money by either debt or equity, but in case of an IPO it is by equity). Underwriters act as the middlemen between companies and the investing public. Some examples of biggest underwriters are Goldman Sachs, Credit Suisse, JP Morgan, and Morgan Stanley.
- When a company decides to go public, the first thing it does is to hire an investment bank. A company can sell its shares on its own, but realistically, an investment bank is required as it acts as an intermediary during the whole process.
- The investment bank and the company will first meet to negotiate the deal. Items usually discussed in such meetings are –
- The amount of money a company will raise,
- Type of securities to be issued
- Details of the underwriting agreement.
- The deal can be designed in a variety of ways. In some deals the underwriter guarantees that the amount will be raised by buying the entire offer and then reselling to the public. But in some of the deals the underwriter offers to sell securities for the company but does not guarantee the amount raised.
- In order to reduce the risk of offering, Investment banks may a syndicate of underwriters. In such cases one underwriter leads the syndicate and the others sell a part of the issue.
- Once all sides agree to a deal, the investment bank starts assembling a registration statement, which is to be filed with the SEC. The document of registration statement contains information about the offering. Apart from this it also contains company information such as financial statements, management background, legal problems if any, where the money is to be used etc.
- A cooling off period is required by the SEC. During this period the SEC investigates and makes sure that all the material information has been disclosed.
- Once the SEC approves the offering, an effective date is set, as to when the stock will be offered to the public.
- On the other hand, during the cooling off period the underwriter puts together the red herring. The red herring is an initial prospectus containing all the information about the company. But it does not contain any information on the offer price and the effective date (which aren’t known at that time).
- Once the red herring is in hand, the underwriter and company starts to hype and build up interest for the issue. They bring the road show where the big institutional investors are courted.
- As the effective date approaches, the underwriter and company start deciding on the price. This decision depends upon the company, the success of the road show and, and current market conditions.
- The securities are finally sold on the stock market and the money is collected from investors.
- Based on the percentage of the value of the shares sold the underwriters keep the commission. Generally the lead underwriters take the highest commissions. Such commissions can sometimes be as high as 8% in some cases.
IPO Pricing Methods-
- Fixed Price Process-
- Price at which the securities are offered is known in advance to the investor.
- In the Fixed price method of pricing, the demand for the securities offered is known only after the closure of the issue.
- Payment is made at the time of subscription, while the refund is given after allocation.
- Book Building process-
- Indicative price range is known to the investors and the price at which securities will be offered is not known in advance.
- In this pricing process the demand for the securities offered can be known every day.
- In this method the payment is made only after allocation.
Advantages of an IPO
Access to more Capital: A company can raise huge amount of funds to finance for its capital expenditure, working capital requirements, expansion, modernization, diversification etc.
No or Zero Cost of Capital: Company does not have to pay any interest on capital raised from the public. Also there is no need of repayment of capital as well, except on winding up of company. In such a case the company has to pay the residual amount after it pays all other creditors like bank loans, debentures, preferential shares etc.
Easy to raise new capital: As it is difficult for private companies to raise capital, by going public, raising capital becomes comparatively an easier task.
Pricing and Valuations: IPO enables correct valuation for the company, as the share price is a true reflection of the financial soundness of a company. Also this would aid in case company wants to go for mergers and acquisitions.
Helps in Owner Diversification: Most of the funds of the founders are blocked in the firm till the firm flourishes and becomes more valuable. Because of an IPO, they can sell some stake to diversify their holdings and can reduce the risk of their personal portfolios.
Building Brand Image: It increases the reflectivity and reputation of the company. This leads to enhancement of the company’s brand image.
Liquidity: When the shares of the Company are listed on the stock exchange, they can be easily traded. This helps in providing more liquidity.
Employee Prestige and Retention: Employee prestige and confidence in the company can increase. With the advent of the IPO, a Company can attract as well as retain its employees by offering them stock options/stock purchase plans.
Disadvantages of an IPO
Dilution of control: Dilution of ownership makes the company susceptible to future takeovers.
Expensive and time consuming: The whole process of an IPO takes substantial amount of management time and efforts. Also it involves very high expenses like that of underwriter, lead manager, investment banker, etc.
Regulations: It increases the regulatory monitoring of the firm to ensure that the firm is making filings along with relevant disclosures.
Accountability: The firm is accountable to investors, also the cost of maintaining investor relations are high.
Disclosures: The firm is subject to timely disclosure of information. Maintaining secrecy over expansion plans and market strategies becomes difficult.
Career in IPO
If you want to make a career in IPO you can get in through a job in an Investment bank. To get into an investment bank make sure that you have finance knowledge. Graduates or MBA graduates with top grades and from top colleges are usually hired. Initially you may be hired as an analyst. With experience you will be promoted to higher positions like associates.
List of underwriting companies of the world
- Goldman Sachs
- J.P. Morgan
- Merrill Lynch
- Morgan Stanley
- Deutsche Bank
- Credit Suisse
- UBS Investment Bank
- Wells Fargo Securities
1. Who is a retail investor?
A retail investor is an investor who applies or bids for securities of or for a value of not more than Rs.2,00,000.
2. Can a retail investor bid in a book-built issue?
Yes, He can bid in a book-built issue for a value not more than Rs.1,00,000.
3. Can one change or revise their bid?
Yes, the changes can be made with help of the form for changing/revising the bid that is available along with the application form. But the process of changing should be completed within the date of closure of the issue.
4. How long does it take for the shares to get listed after the issue?
The listing on the stock exchanges is done within 7 days from the finalization of the issue. Generally, it is around 3 weeks after the closure of the book built issue. In case of fixed price issue, it is around 37 days after closure of the issue.
5. What is a Cut Off Price?
In Book building issue process, the price band or a floor price has to be indicated by the issuer in the red herring prospectus. The discovered issue price can be any price in the price band or it can be any price above the floor price. This issue price is called “Cut off price”.
6. What is the meaning of a draft prospectus?
A draft prospectus contains all the information on the financials of the company, promoters, background, tentative issue price etc.The draft prospectus needs to be filed by the Lead Managers with the Securities & Exchange Board of India (SEBI) to provide issue details.
7. What is the floor price?
It is the minimum price at which bids can be made, usually used in book building method of pricing.
8. Are the terms, issue price for placement portion and net offer to public the same?
9. What is a bid lot?
It is the pre-determined number of shares which have to be applied for by an investor.The lot size is different for each issue and it also depends on the company which is issuing the shares.
10. Is it compulsory to have a demat account to apply in an IPO?
Yes it`s mandatory to have a demat account in case of an IPO.