A private company launches an Initial Public Offering (IPO) when they approach the general public for the first time to offer its shares. An IPO is a transformative event in any company’s journey allowing them to go public. Post a company’s IPO, its visibility, financial muscle and presence are likely to increase substantially .
Once an entity is public, people can invest in the company by purchasing its shares through the stock exchange. After someone purchases the shares, they become part owners of the company. Like any other owner, they are entitled to its rewards (dividends) and will also have to bear the risks.
During an IPO the company sells its shares to retail and institutional investors. Retail investors usually include individuals with limited capital who might want to buy some shares. Conversely, some institutional investors opt for a huge chunk of shares. A few examples of such investments include mutual funds, hedge funds, and insurance companies.
What is the full form of IPO?
The IPO full form in the stock market stands for Initial Public Offering (IPO). Launching an IPO is a big step for any company as it helps in raising a lot of capital. This gives the company greater leverage to pursue and achieve business goals which otherwise seemed unachievable soon; for instance, rapid expansion. The increased transparency and share listing credibility can also be a factor that helps obtain better terms when seeking borrowed funds.
Any new business activity requires funds which can be scarce for some companies. Hence, merely looking at financing requirements will not suffice in determining if a company should go public. It may decide to go public, particularly when it reaches a stage wherein it believes it is mature enough for the rigours of SEBI (Security Exchange Board of India). Alongside, it should also believe that it is steady enough to take on responsibilities it will owe to public shareholders.
Recently, this growth stage usually occurs when a company has achieved unicorn status. A company is said to have reached this level when it hits a private valuation of ~$1 billion. However, low-valued private companies with strong fundamentals and proven profitability potential have also managed successful IPO listings.
Examples of IPOs
Considering some recent and ancient examples of IPOs in Indian markets:
Life insurance Corporation of India: LIC’s IPO was the largest in India. The issue opened on May 04, 2022. The government aimed to get INR 21,000 crores by offloading 3.5% of its shares. This undertaking was made to enhance the brand image and provide a public market for equity shares in India.
Reliance Industries: Reliance, then in the textiles manufacturing business, had issued 2.8 million equity shares of INR 10 each in its first equity sale to the public investors in November 1977. Reliance founder Dhirubhai Ambani is said to have introduced an equity cult in India through this public offer.
How does an Initial Public Offering (IPO) Work?
Once the company decides to go public, it must now perform a series of steps to ensure a successful IPO. The first and foremost step would be to appoint a merchant banker. Merchant bankers are called Book Running Lead Managers (BRLM)/Lead Managers (LM). The job of a merchant banker is to assist the company with various aspects of the IPO process, including:
● Conduct due diligence on the company filing for an IPO, ensuring their legal compliance and issuing a due diligence certificate.
● Work closely with the company and prepare their listing documents, including Draft Red Herring Prospectus (DRHP).
● Underwrite shares – By underwriting shares, merchant bankers essentially agree to buy all or part of the IPO shares and re-sell the same to the public.
● Help the company arrive at the price band for the IPO. A price band is the lower and upper limit of the share price within which the company will go public.
● Help the company with the roadshows – this is like a promotional/marketing activity for the company’s IPO.
● Appointment of other intermediaries, namely registrars, bankers, and advertising agencies. The Lead managers also develop various marketing strategies for the issue.
Once the company partners with the merchant banker, they will work towards taking the company public.
Steps to an IPO
Every step in the IPO process must happen under the SEBI guidelines. In general, the following are the sequence of steps involved.
● Appoint a merchant banker – In case of a large public issue, the company can appoint more than 1 merchant banker
● Apply to SEBI with a registration statement – The registration statement contains details on what the company does, why the company plans to go public and the financial health of the company
● Getting a nod from SEBI – Once SEBI receives the registration statement, SEBI takes a call on whether to issue a go-ahead or a ‘no go’ to the IPO.
● DRHP – If the company gets the initial SEBI nod, then the company needs to prepare the DRHP. A DRHP is a document that gets circulated to the public. Along with a lot of information, this document should contain the following details:
1. The estimated size of the IPO
2. The estimated number of shares being offered to the public
3. Why the company wants to go public and how does the company plan to utilize the funds along with the timeline projection of fund utilization
4. Business description including the revenue model, and expenditure details
5. Complete financial statements
6. Management Discussion and Analysis – how the company perceives future business operations to emerge
7. Risks involved in the business
8. Management details and their background
● Market the IPO – This would involve TV and print advertisements to build awareness about the company and its IPO offering. This process is also called the IPO roadshow.
● Fix the price band – Decide the price band between which the company would like to go public. However, this pricing must be realistic and can’t be way off the general perception. If it is, then the public will not subscribe to the IPO.
● Book Building – After the roadshow and the price band fixing, the company now has to officially open the window during which the public can subscribe for shares. For example, if the price band is between Rs. 100 and Rs. 120, the public can choose a price they think is fair enough for the IPO issue. The process of collecting all these price points and the respective quantities is called Book Building. It is perceived as an effective price discovery method.
● Closure – After the book building window is closed (generally open for a few days), the authorities decide the price point at which the issue gets listed. This price point is usually the price at which maximum bids have been received.
● Listing Day – This is the day when the company gets listed on the stock exchange. The listing price is the price determined based on market demand and supply on that day, whether the stock is listed at a premium, par or discount of the cut-off price.
Advantages and Disadvantages of an IPO
While an IPO is a worthy objective with many potential benefits, it also has many risks and disadvantages. Thus, an IPO may not be suitable for every company. Although many people believe that every successful company is public, many private companies also thrive, such as Dell, Cargill, and Koch Industries. Hence, a company must weigh all the advantages and disadvantages before deciding to go public.
Fundraising: Money is the most often cited advantage of an initial public offering. Companies may use the proceeds to finance R&D, hire new employees, reduce debt, or bankroll any other possibilities.
Exit Opportunity: Every company has stakeholders who have contributed significant amounts of time, money, and resources, hoping to create a successful company. These founders and investors often go for years without seeing any significant financial return on their contributions. An IPO is a significant exit opportunity for stakeholders to sell their shares and redeem their return on investment.
Publicity and Credibility: If a company hopes to continue to grow, it will need increased exposure to potential customers who know about and trust its products. An IPO can provide this exposure as it thrusts a company into the public spotlight. Not only do companies receive a great deal of attention when they decide to go public, but they also receive credibility.
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.
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.
More About IPO
Frequently Asked Questions
At its core, the IPO price is based on the company’s valuation using fundamental techniques. The most common approach used is discounted cash flow.
One shouldn't invest in an IPO just because the company is garnering positive attention, as it could be purely due to market sentiments. Investors should remember that a company issuing an IPO lacks a proven record of operating publicly.