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When you are browsing through the pages of the newspaper, you see an announcement of an IPO offering by a company. If you are among the people who are wondering what an is IPO or what the meaning of IPO is, here is a guide to help you through the basics of the term and concepts around it.
Key takeaways
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An IPO (Initial Public Offering) is the process by which a private company becomes publicly traded by offering shares to the public.
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Companies embark on an IPO to secure funds for growth, enable early investors’ exits, boost credibility and liquidity, and expand opportunities such as acquisitions or employee stock plans.
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Two common types of IPO methods are fixed-price offerings and book-building: one sets a fixed share price, the other uses a price band where investors bid within a range.
IPO Meaning/Definition
IPO means Initial Public Offering. It is a process by which a privately held company becomes a publicly traded company by offering its shares to the public for the first time. A private company that has a handful of shareholders shares the ownership by going public by trading its shares. Through the IPO, the company gets its name listed on the stock exchange.
What is an IPO in the Stock Market?
The question many first-time investors often ask is: What is an IPO in the stock market? In simple words, an IPO (Initial Public Offering) is a process in which the shares of a privately owned company are sold to the market and the company becomes publicly traded. This not only assists the company in raising capital but also offers the investors a chance to purchase its shares and become partial owners. Investing in an IPO is a smart move; however, before investing, one must know what is an IPO in the stock market.
How Does a Company Offer an IPO?
A company, before it becomes public, hires an investment bank to handle the IPO. The investment bank and the company work out the financial details of the IPO in the underwriting agreement.
The company prepares and files the registration document (RHP or Red Herring Prospectus) with SEBI (Securities and Exchange Board of India), which then reviews it for disclosure compliance. After SEBI allows the IPO to proceed, the underwriters and the company sign the underwriting agreement during the pricing stage, which is typically the day before the closing date.
Why Does a Company Offer an IPO?
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Offering an IPO is a money-making exercise. Every company needs money, it may be to expand, to improve their business, to better the infrastructure, to repay loans, etc.
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Trading stocks in the open market means increased liquidity. It opens the door to employee stock ownership plans like stock options and other compensation plans, which attract the talent in the cream layer.
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A company going public means that the brand has gained enough success to get its name listed on the stock exchanges. It is a matter of credibility and pride for any company.
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In a demanding market, a public company can always issue more stock. This will pave the way to acquisitions and mergers, as the stocks can be issued as part of the deal.
Types of IPOs
If you are a new investor, you may find all the jargon around an initial public offering a little baffling. To clear your confusion, there are two major categories of IPOs offered by companies.
Fixed Price Offering
A fixed price offering is pretty straightforward. The company announces the price of the initial public offering in advance. So, when you partake in a fixed price initial public offering, you agree to pay in full.
Book Building Offering
In a book building offering, the stock price is offered in a 20 per cent band, and interested investors place their bid. The lower level of the price band is called the floor price, and the upper limit, the cap price. Investors bid for the number of shares and the price they want to pay. It allows the company to test interest for the initial public offering among investors before the final price is declared.
Should You Invest in an IPO?
Deciding whether to put your money into an IPO of a relatively new company is indeed tricky. Being a skeptic is a positive attitude to have in the stock market. Here are some important things to consider while deciding whether to invest in IPO.
Background checks
Understanding the company and its projection is crucial before you invest in its IPO. While the company may not have historical data for stock, it can provide other pertinent details through the prospectus. The red herring is the data on the IPO details, which is provided in the prospectus; you need to scrutinise it. You also need to know about the fund management team and their plans for IPO generated fund utilisation.
Who is Underwriting
Usually, an IPO or other large, high-profile new issue with a high success potential is managed by large, reputable investment banks (often called major brokerages or underwriters) that have the necessary capital, distribution network, and market influence to successfully market and distribute the new issue.
Lock-up Periods
Lock-up periods refer to the period after IPO during which the pre-IPO investors are not allowed to sell their shares for a decided time. This helps in stabilising the stock by preventing large chunks of shares from entering the market, which could cause price fluctuations.
This is also why, IPO often takes a deep downtrend once it goes public as when the lock-up period is over, a large number of shares may be sold suddenly, which increases supply and can drive down the prices. While generally the share prices drop, it's not guaranteed. It largely depends on the market conditions and the number of shareholders who choose to sell at once.
Flipping
People who buy stocks of the company going public and sell off on the secondary market with the view to getting quick money are called flippers. Flipping initiates the trading activity.
IPO Advantages
Access to a growing company: When a company receives fresh cash flow through an IPO and hits the growth path, it creates more value for investors. Companies that go public usually have higher growth prospects and ambitious expansion plans.
An Initial Public Offering allows you to become an early shareholder, and you can benefit from the company's growth trajectory. Historically, successful IPOs have generated substantial returns for early investors, making them attractive investment options.
Access to innovative companies: IPOs give you access to invest in new and innovative companies that are pioneers in implementing technological advancements, bringing new products, services, or business models to the market. Investing in such companies allows investors to participate in growing, cutting-edge businesses with the potential to reshape the industry. By identifying promising companies, you can capitalise on transformative trends and industry shifts.
Liquidity and marketability: Becoming a public company improves the liquidity and marketability of the company’s shares. When the company becomes public, its investors can buy and sell stocks in the stock market.
Diversification: Including IPOs in your portfolio contributes to diversification, which is a critical risk management strategy. IPOs allow investors to expand their investments into new companies and beyond their existing holdings.
Diversification lowers the concentration risk associated with investing in a single company or sector and improves return potential.
Early entry discount: Through an IPO, you can invest in a company at an early stage, which gives you access to buy shares at a lower rate than the post-IPO market price. The early entry offers an advantage and the potential for higher returns in the long run.
Disadvantages of IPO Investment
Volatilities and uncertainties: Although IPOs offer opportunities to invest in innovative and growing companies, they are also highly volatile investment assets and, therefore, risky. In the absence of reliable performance and financial data, the risk of failing to assess the full potential of the company is high.
Limited information: Investors investing in new companies often need to deal with limited information. Private companies are not obligated to disclose the same level of financial and operational details as publicly traded organisations. The lack of information can make it challenging for investors to thoroughly evaluate the company’s fundamentals, competitive landscape, and long-term prospects.
Lock-in period: The lock-in period may prevent you from selling the IPO shares after listing.
It is typically a cooling phase when certain shareholders, such as company insiders and venture capitalists, are restricted from selling their holdings. After the lock-in period, which can last from a few months to a few years, investors may face a decline in the share price due to an oversupply of shares in the market. Hence, it is important to carefully consider the lock-in period and its potential impact on the share price before investing in an IPO.
Things You Should Know Before Investing in an IPO
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Read the legal documents (DRHP/RHP) available on the company or regulatory websites like SEBI. These documents outline the company’s business model, financial condition, and the details of the offering.
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It is this asset of your portfolio which has the highest potential to reward the returns. On the flip side, it can sink your investment without a sign. Remember, stocks are subject to the volatility of the markets.
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You should know that a company which offers its shares to the public is not indebted to reimburse the capital to the public investor.
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You should weigh up your potential risks and rewards before investing in an IPO. If you are a novice, read up on an account from an expert or a wealth management firm. If still in doubt, talk to your personal financial advisor.
Remember, if you invest in an IPO for the company, you are exposed to the fortunes of that company. You bear a direct impact on its success and loss.
How to Apply for IPOs?
Nowadays, it has become easier to apply for an initial public offering because of the online application process. However, if you are a new investor, you need to learn a few things before applying.
The first important thing is funding. Whether it is a fixed price or a book-building IPO, you will have to make a payment in advance, and for that, you must have funding ready. Investors can use their savings or take a loan from a bank or NBFC for the purpose.
However, without a DEMAT account, you can't invest in stocks. So, the next thing you need is to open a DEMAT account. Select a reputed broker with a track record to have a DEMAT.
You can use the DEMAT account not only for IPOs, but to receive all sorts of investment instruments like gold bonds, corporate bonds, shares, and more.
The online process is an easy way to apply. You can do it from the investor portal on the broker's website or by downloading the ASBA form from your bank's net-banking platform.
ASBA stands for Application Supported by Blocked Account (ASBA). It allows banks to block funds in the applicant's account against your bidding for the IPO.
If you apply through the broker, you need to use UPI-enabled payment gateways to make a payment. In either case, cheques and demand draft payments are not accepted for bidding.
Terms Associated With an IPO
There are several terms associated with an IPO, and as an investor, you need to be aware of those terms and their meanings:
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Prospectus: It is a legal document that provides details about the company, its financials, risks, and the offering. It's distributed to potential investors to help them make informed decisions.
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Underwriter: A financial institution or investment bank that helps the company go public by purchasing the shares and reselling them to the public.
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Offer price: The price at which a company's shares are offered to the public during the IPO. It's determined through a process called book-building.
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Book-building: A process of determining the offer price based on the demand from investors. It helps in setting a fair market price for the shares.
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Allotment: It is the process of assigning shares to investors who have applied for shares during the IPO.
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Green Shoe Option (Over-allotment option): An option that allows underwriters to sell additional shares to the public if the demand is higher than anticipated.
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Listing: The process of a company's shares being traded on a stock exchange, making them accessible to the general public.
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Lock-up period: A period after the IPO during which insiders (company founders, executives) are restricted from selling their shares.
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Grey market: A market where shares of a company about to go public are traded before the official listing. It indicates the potential listing price.
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Offer for Sale (OFS): A method of selling shares in which existing shareholders (promoters or other investors) sell their shares to the public, and the company doesn't receive the proceeds.
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IPO subscription: The process of investors applying for shares in an IPO, indicating their interest and the number of shares they wish to buy.
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IPO registrar: A company responsible for processing applications, allocating shares, and managing the refund process for the IPO.
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Listing agreement: A contract between a company and a stock exchange detailing the obligations and requirements of the listed company.
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Flipping: It refers to selling the shares acquired during the IPO shortly after they start trading on the secondary market, typically to make a quick profit.
Eligibility Criteria to Invest in an IPO
If you are planning to invest in an IPO, ensure you fit into the eligibility criteria below:
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Must hold a PAN card.
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Have a valid Demat account.
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Though a trading account is not needed to apply for an IPO, you need a trading account if you want to sell the shares after they get listed.
Conclusion
Knowing what an IPO is will benefit greatly in making informed choices with the help of data, research and analysis. An IPO creates an opportunity for the investor to contribute to the early development of a company and enjoy its growth.
IPOs can also be rewarding when conducted with proper research and due diligence, especially if you want to diversify your portfolio and tap into long-term market opportunities.