What are the risks of investing in IPOs

Initial Public Offerings (IPOs) attract investors because they provide an opportunity to invest in a company at the stage when it enters the public market. However, early access does not automatically mean lower risk or better returns.  

Share prices can move sharply after listing, and business performance may not always match expectations. Understanding IPO risks helps investors evaluate opportunities more carefully and make informed investment decisions. 

Key Takeaways 

What is an IPO? 

When a private company makes its debut on the stock exchange by issuing its shares to the general public, it is referred to as an Initial public offering (IPO).  

Simply put, an IPO is a process by which a privately-owned company is transformed into a public company whose shares are listed on the exchange. Most companies opt for an IPO to bring in liquidity and raise funds. This capital infusion can then be used for various requirements, including expanding and scaling a business, optimising operations, improving infrastructure, paying off debts, etc.  

Risks of Investing in an IPO 

Let’s take a look at some of the main risks of investing in an IPO: 

Over-Valuation Issues

Valuation is the process of fixing a fair price for the company's shares at the time of the IPO. It is influenced by factors such as demand for the issue, the company's growth prospects, comparable industry peers, and prevailing market conditions. When an IPO is priced attractively relative to the company's fundamentals, share prices may rise after listing.  

However, this is not guaranteed. In some cases, market excitement or aggressive pricing by the issuer may result in an IPO being priced higher than what the company's underlying financials justify.  

If the market later reassesses the company's true value, the share price may decline, and investors who purchased at the issue price may face losses. Reading the RHP carefully, especially the valuation rationale and peer comparison disclosures, can help investors assess whether the issue price is reasonable before applying. 

No Assurance of Allotment of Shares 

Applying for an IPO does not guarantee that you will receive shares. When an IPO is oversubscribed, which means meaning more shares are applied for than are available, SEBI's allotment framework comes into play.  

For retail individual investors (RIIs), SEBI rules require that as many unique investors as possible be allotted at least one lot, and to ensure fairness, a computerised lottery system is used to determine allotment. This means that even a valid, fully funded application may not result in a share allotment.  

Under SEBI's T+3 framework (mandatory from December 1, 2023), application money for unallotted shares is unblocked and refunded on T+2, that is, one day before the listing date, enabling faster access to funds for unsuccessful applicants. Investors should factor in the possibility of non-allotment and avoid over-committing funds solely based on the expectation of receiving shares. 

Read More About: How to Apply For an IPO? 

High Volatility 

Newly listed stocks can experience sharp price swings, particularly during the first day of trading. Under SEBI's T+3 listing framework (effective December 1, 2023), IPO shares are listed on the exchange within three working days from the close of the subscription period. On the listing day, a one-hour pre-open call auction session runs from 9:00 AM to 10:00 AM to aid in initial price discovery before normal trading begins.  

Despite this mechanism, share prices may move significantly above or below the issue price on listing day, driven by investor sentiment, demand-supply imbalances, and broader market conditions.  

If the share price falls after listing, investors who applied at the issue price may face losses, particularly if they need to sell during this volatile initial phase. 

Insufficient Information About the Company 

Even though IPOs are generally supported by detailed disclosures, investors may still find it difficult to fully assess a company, especially when it has a limited operating history. Investors may have to struggle with evaluating the company’s shares in the absence of sufficient historical data. 

Post-Listing Selling Pressure 

After listing, share prices can come under pressure if large shareholders begin selling their holdings. Pre-IPO investors, promoters, and anchor investors are subject to lock-in periods under SEBI regulations, which restrict them from selling shares immediately after listing.  

However, once lock-in periods expire, increased supply in the market can weigh on prices. Retail investors should be aware that listing day performance does not necessarily reflect the stock's long-term trajectory, and that institutional exits after lock-in expiry can create short-term volatility. 

Read More About: Types of IPO 

Points to Remember Before Investing in IPO 

Before an IPO goes live for subscription, a company files a Draft Red Herring Prospectus (DRHP) with SEBI, which is a preliminary document that covers the company's operations, financials, risk factors, and intended use of proceeds but does not include the final issue price or dates.  

After SEBI evaluates it and the business makes the necessary revisions, the final Red Herring Prospectus (RHP) is filed. The RHP contains all of the specifics, including the price band and issue schedule, and it is the document that investors should review before applying.  

The DRHP is publicly available on SEBI's website (sebi.gov.in) after SEBI's observations are issued. The final RHP, which contains the price band and subscription schedule, is filed with the Registrar of Companies (RoC) and is accessible on the BSE and NSE websites, the company's investor relations page, and the registrar's platform. Investors should ensure they are reading the final RHP, not just the DRHP, before applying. 

Do not invest in an IPO based on advertisements and promotions. Be cautious of expectations of quick gains and avoid making decisions based only on public discussions or promotions. 

Review your investment objective and make an informed decision based on your risk appetite. 

It is not advisable to invest in an IPO using borrowed funds. In case of losses, the financial damage would only get amplified if one has taken a loan to invest in the IPO.  

Some IPO Related Terms: 

Price Band 

The price range jointly set by the issuer company and underwriter, within which an investor can bid for an IPO, is called the Price Band. A floor price is the minimum price, and the ceiling price is the maximum price at which you can bid for an IPO. 

Lot Size 

The predetermined number of shares that must be applied to buy an IPO. It is the minimum number of shares an investor can bid for in an IPO. 

Over-Subscription 

When the number of shares applied for exceeds the shares offered in an IPO, then the IPO is said to be oversubscribed. 

Minimum Subscription 

Minimum subscription refers to the threshold of at least 90% of the total fresh issue (new shares issued by the company) that must be subscribed to for the IPO to proceed. This condition applies to the fresh issue component only, Offer for Sale (OFS) portions, where existing shareholders sell shares, and are not subject to the minimum subscription requirement. If the 90% threshold on the fresh issue is not met, the issue is cancelled and the application money refunded. 

Read More About: What is Oversubscription in IPO? 

Conclusion 

Investing in an IPO can offer access to companies at an early stage of their public journey, but every opportunity should be evaluated with care. Listing performance, valuation, financial position, market conditions, and long-term business potential all play an important role in the outcome. Understanding the risk of investing in ipo allows investors to move beyond market excitement and make decisions based on facts, suitability, and their own financial goals rather than short-term expectations. 

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