What is IPO
Whether or not to invest in an initial public offering is a choice of an investor, but it is one way to accentuate the earning potential of your investment. Picking the right IPO offer to pose a bit of a challenge, but if you successfully overcome it, IPOs could be the most vital asset in your portfolio.
What is IPO ?
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.
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. Later, along with the underwriting agreement, they file the registration statement with SEC. SEC scrutinizes the disclosed information and if found right, it allows a date to announce the IPO.
When a company lists its securities on a public exchange, the money paid by the investing public for the newly-issued shares goes directly to the company (primary offering) as well as to any early private investors who opt to sell all or a portion of their holdings (secondary offerings) as part of the larger IPO. An IPO, therefore, allows a company to tap into a wide pool of potential investors to provide itself with capital for future growth, repayment of debt, or working capital. A company selling common shares is never required to repay the capital to its public investors. Those investors must endure the unpredictable nature of the open market to price and trade their shares. After the IPO, when shares are trade market, money passes between public investors. For early private investors who choose to sell shares as part of the IPO process, the IPO represents an opportunity to monetize their investment. After the IPO, once shares are traded in the open market, investors holding large blocks of shares can either sell those shares piecemeal in the open market or sell a large block of shares directly to the public, at a fixed price, through a secondary market offering. This type of offering is not dilutive since no new shares are being created
Once a company is listed, it is able to issue additional common shares in a number of different ways, one of which is the follow-on offering. This method provides capital for various corporate purposes through the issuance of equity (see stock dilution) without incurring any debt. This ability to quickly raise potentially large amounts of capital from the marketplace is a key reason many companies seek to go public.
An IPO accords several benefits to the previously private company:
- Enlarging and diversifying equity base
- Enabling cheaper access to capital
- Increasing exposure, prestige, and public image
- Attracting and retaining better management and employees through liquid equity participation
- Facilitating acquisitions (potentially in return for shares of stock)
- Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc.
- There are several disadvantages to completing an initial public offering:
- Significant legal, accounting and marketing costs, many of which are ongoing
- The requirement to disclose financial and business information
- Meaningful time, effort and attention required of management
- The risk that required funding will not be raised
- Public dissemination of information that may be useful to competitors, suppliers and customers.
- Loss of control and stronger agency problems due to new shareholders
- Increased risk of litigation, including private securities class actions and shareholder derivative actions
Why Does a Company Offer an IPO?
1. 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
2. Trading stocks in the open market mean increased liquidity. It opens door to employee stock ownership plans like stock options and other compensation plans, which attracts the talents in the cream layer
3. A company going public means that the brand has gained enough success to get its name flashed in the stock exchanges. It is a matter of credibility and pride to any company
4. In a demanding market, a public company can always issue more stocks. This will pave the way to acquisitions and mergers as the stocks can be issued as a 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
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, 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 sceptic is a positive attitude to have in the stock market.
The Company obviously does not have enough historical data to back your decision, because it is just going public now. The red herring is the data on the IPO details which is provided in the prospectus, you need to scrutinize it. Know about the fund management team and their plans for IPO generated fund utilization.
Who is Underwriting
The process of underwriting is raising investments by issuing new securities. Be secretive of the underwriting of small investment banks. They may be willing to underwrite any company. Usually, an IPO with a success potential is backed by big brokerages that have the ability to endorse a new issue well.
Often IPO takes a deep downtrend after the IPO goes public. The reason behind this fall of the share price is the lock-up period. A lock-up period is a contractual caveat that refers to a period of time the company’s executives and investors are not supposed to sell their shares. After the lock-up period ends, the share price experiences a drop in its price.
People who buy stocks of the company going public and sell-off on the secondary market in the view to get quick money are called flippers. Flipping initiates the trading activity.
Things you should know before investing
1. If you have bought an IPO for the company, you are exposed to the fortunes of that company. You bear a direct impact on its success and loss
2. It is this asset of your portfolio that has the highest potential to reward the returns. On the flip side, it can sink your investment without a sign. Remember stocks are subjected to the volatility of the markets
3. You should know that a company that offers its shares to the public is not indebted to reimburse the capital to the public investors
4. You should weigh up your potential risks and rewards before investing in an IPO. If you are a novice, read up an account from an expert or a wealth management firm. If still in doubt, talk to your personal financial advisor
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 payment. In either case, cheques and demand draft payments are not accepted for bidding.