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An initial public offering (IPO) is the process in which a private company offers shares to the public and raises funds. After an IPO the shares are traded on the stock exchanges. The capital market consists of the primary and the secondary market. It is the primary market that is used by companies for raising funds from the investors by making an initial public offer. Before the IPO the shareholders in a company include the founders, angel investors, and venture capitalists; but during an IPO offer, the common public or investors can also buy shares from the company. An investor should be aware of the things to consider before investing in an IPO.
There are reasons for a company to go public. Every company requires capital to fund its expansion plans or pay off existing debts which they can fulfill with the funds they collect. The initial angel investors and the venture capitalists get a route to sell their stake and generate returns on their investment and the publicity done helps in creating more awareness about the company.
What is the procedure for the Initial Public Offering (IPO)?
The private company takes the following steps to go public-
Selecting the underwriters-
This is the first step where the company selects an investment bank as an underwriter. The company may even decide to choose a few underwriters to manage different parts of the IPO. The functions of the underwriters include the preparation of documents, filing, and marketing. They present proposals for the initial price, the number of shares, and the time frame that would be required for going public.
Creating the Red Herring prospectus-
This is the next step of the IPO process and is carried out with the help of underwriters. The ‘Red Herring Prospectus’ as a document is very useful to the investors as it provides details of the company’s operations, financials, and the objective of the promoters for raising funds. It also explains how the company proposes to utilize these funds. The Red Herring Prospectus can be found on the official website of SEBI.
Investors should study the following details in a Red Herring prospectus before making an investment decision; the details of the offer, capital structure, how the company plans to utilize the funds, industry overview, how the company conducts its business, financial information, strengths of the company, qualifications of the promoters and directors, strategies of the company to grow its business and the risks that could impact the business.
Approval of SEBI-
The Red Herring prospectus is submitted to the Securities and Exchange Board of India, and if they find it satisfactory they give the go-ahead; otherwise, changes are made before sharing it with the public.
Approval of the Stock Exchange-
The company needs the approval of the stock exchange for listing. The stock exchanges have the listing department to grant approval for listing. The NSE and the BSE have their criteria for listing which the company should comply with.
Shares issued and Listing-
On the date of the IPO, the company offers its shares to the public and the capital which is received is recorded as shareholders equity on the balance sheet. Investors who want the shares of the company apply for it through the application process and if allotted the shares get credited to their Demat account. The stock is now listed and traded on the stock exchange.
How can a person invest in an IPO?
The investor should go through the prospectus of the company and study all the details so that he can make an informed decision. There are many IPOs that will be available every month and the investor can select the best among them according to his finances. But before applying for an IPO the investor should have a Demat account where he can store the shares electronically.
The Demat account can be opened by deciding on the Depository Participant (DP) which is an authorized bank or a broker that you want to open the account with. The selection of DP can be done considering the brokerage charges and the annual charge. Submit copies of the KYC form along with PAN Card, residence proof, ID proof, and passport-sized photographs.
Application for the IPO-
The investor can apply for an IPO from his bank account or the trading account and should be familiar with the ASBA facility which is “Application Supported by blocked Amount.” ASBA is the authorization by the investor to the bank to block the application money for the IPO in the bank account. The application money would be debited from his bank account only if the application is selected for allotment.
The ASBA application forms are available both in physical as well as Demat form. The investor submits the ASBA after filling in details like his name, PAN number, Demat account number, bid quantity, bid price, and other details and the bank blocks the amount in their account. A price range is there and an investor has to bid within the price range. The investor should ensure that all the details are correct otherwise his application would be rejected. The blocked amount in his account earns him interest until the allotment process is started.
Allotment of Shares-
Once the process for the submission of bids is completed a computer process is run to eliminate bids that are not properly submitted.
If the cumulative total number of bids is less than the total number of lots offered the full allotment is done to everyone who has applied for the shares. In case there is a large over-subscription then the lots are allotted on a lucky draw basis which is computerized. When there is a lucky draw a lot of people are not allotted shares as their name is not there in the lucky draw. If the investor is lucky to get full allotment he would receive a confirmatory allotment note in six working days after the IPO process is done. Once the shares are allotted, they are credited to his Demat account.
Types of IPO-
There are two types of IPO, fixed price and book building offering. The details are-
Fixed price offering–
- In the fixed price offering the price at which the securities are offered and are allotted would be informed in advance to investors.
- The demand for securities offered is known after the closure of the issue.
- 50% of the shares offered are reserved for applications below Rs 2 lakh and the remaining for bigger amount applications.
Book Building Offering-
- In the book building offer a 20% price band is offered by the issuer within which the investors have to bid and the final price is determined after closure of the bidding.
- The demand for securities offered at various prices is available on the stock exchange website on a real time basis during bidding.
The reservation of shares is; 50% of the shares offered are for QIBs, 35% for Nonretail, and 15% for retail investors.
Some things to consider before investing in an IPO-
1) Study the past of the company-
The investor should be aware of the past of the company and how it has performed in the previous years. This will make him understand why it is coming with an IPO and what the requirements are.
2) Read the Draft Red Herring Prospectus-
The Draft Red Herring prospectus contains many important details about the company’s operations, financials, details of the offer, capital structure, strengths of the company, how the company conducts its business, and how it plans to utilize the funds collected.
3) Utilization of Capital-
Check and find how the company would be utilizing the money collected from the IPO. If it is for retiring debt then it may not be so good, but if it mentions that the proceeds would be for retiring some debt and further expansion of the business then it is a good idea that the business would grow in the future too.
4) Do you understand the business?
The person who is going to invest should understand the business that a company is operating in. This will make him understand the cycles in the business and if there is a new opportunity for growth. The growth opportunity will create value for the shareholder. A thorough understanding of a business will help him stick with the stock and the business instead of acting just on hearsay.
5) Valuation of the company
One of the most important things to check is the valuation of the company and whether it is fairly valued or overvalued. This can be done by comparing it with the peers and whether the valuations are in line with the peers and the industry. Study the financial numbers. This will throw some light.
6) Management Team
The management team in a company is very important. A good management team plans and executes the work and resources of a company to achieve maximum work output, pushing expansion and marketing, and tries to reach the goals on time. If the team is not good it may lead to losses and delays in all the plans. The investor should study the management, promoters, directors, and the qualifications they have. If there is any criminal case or pending litigation against this personnel it is to be taken note of.
7) Risk Factors-
The company mentions the potential risks that could affect their business in the section ‘Risk Factors.’ These may be routine risks, but some may have to be considered seriously. If there are many pending litigations against the company it is better to avoid the IPO. Try to find risks that could affect the company’s growth in the future.
8) Hype over the IPO-
Don’t get carried away by the hype surrounding the IPO and always make an informed decision. If the IPO is priced aggressively, you may not be able to make good returns. Identify the right IPO to invest in.
9) Investment Goals-
There should be always a balanced approach to the investment process accounting for the risks and rewards. The IPO should match your investment goals.
10) Investment Horizon-
The investment horizon should be always clear. Do you want to book gains on a listing day or do you wish to keep the shares for the long term? Keeping for the long term entails that the fundamentals of the company should be very sound and you should not sell in panic even if the value of the stock falls by a third or half. If you have a good risk appetite you can always keep the shares for the long term.
Advantages and Disadvantages of IPO-
The advantages and disadvantages of an IPO are-
- The company gets funds which can be used to finance research and development, reduce debt, hire new employees, and acquire new technology and there are many other possibilities. The money can bring growth to the company.
- The angel investors and venture capitalists who have invested in the company have to go over a number of years without any return. The IPO provides them an opportunity to exit.
- Publicity received by the company brings it in front of the investors and the public, enhancing its image. The company goes through a lot of scrutiny and this increases the credibility of the company.
- The stock options of a company are useful if there is an exit opportunity. The company has to hire the best of employees in order to survive in a competitive environment. When a company has gone public it has the option to issue shares as payment rather than using cash.
- An IPO is costly and the underwriters are paid huge fees. Besides this there are other expenses like legal fees, auditor fees and registration fees.
- The responsibilities on a company increase. It is required to file financial statements according to SEBI requirements. Stringent financial controls and audit requirements have to be met. There is an increased time and effort required by the management on reporting.
- Once a company is listed, it is on the radar of analyst and investors. The company may have to meet short term quarterly target reporting. Some of the founders like to take a long term view of the company instead of the short term view of the stock market.
- Since the public have put their money in the company they expect the company to act in their interest otherwise the company faces a lot of criticism.
The IPO is one of the ways for an investor to earn good returns, but he should read the prospectus carefully and find out details about the company. If the IPO is overpriced they should avoid the issue unless it fits with his investment goals and time horizon. An investor should be well aware of the things to consider before making an investment decision and invest in an IPO that is likely to generate good returns.