Many people have different opinions about IPOs. What is it, and how does it work?
In this post, I will try to give you quick and straightforward information about what is IPO in share market and how it works.
It will be beneficial to have at least basic knowledge about the share market before going through this post.
Now let’s start digging in!
What is IPO in Share Market?
IPO stands for Initial Public Offering. An IPO means that a company has decided to go public by selling its shares to the public for the first time.
To become a public company, a certain number of requirements involving legalities and capital structure must be fulfilled.
Different authorities regulate the process of going public, like SEBI and SEC.
Ipo’s primary motive is to raise capital or create additional cash flow for further expansion of business. Many companies go through an IPO because they need money and have no other way of getting it.
After the IPO, the company started trading on stock exchanges.
Note: IPO is a way to raise capital by offering shares of a company to the general public.
Let’s take an example to understand better what is IPO in share market:
Let’s assume ABC Ltd. is an electric bike manufacturer company in India, planning to expand their business across the country. For this, they need funds for factory expansion and other administrative work.
To get these funds, ABC Ltd. decided to go public by issuing an IPO. It means they are selling their shares to the public for the first time, rather than giving it to any investor or company, like banks or financial institutions.
Thus, everyone who wants to invest in ABC Ltd can buy shares by subscribing to the IPO of ABC Ltd by paying some amount to the company.
Once this is done, what happens is that ABC Ltd. now has funds for its expansion plans, which it uses to keep on expanding its business across India.
Many buy these shares for investment purposes because they believe that ABC Ltd is a profitable company and will give high returns on their investments in the future.
This whole process of releasing new shares to the public is called an IPO.
Why is an IPO required for a company?
Companies go public for a variety of reasons. Some of the reasons are as follows:
1. To Expand Business:
This is the primary reason why companies prefer to have an IPO. It helps them in expanding their business because of increased capital available for further investment.
2. Debt:
This is another reason why companies prefer to have an IPO. It helps them reduce their financial debt because of the money raised through the sale of equity shares.
It also helps them pay off some of their old debts and revolving money for new projects.
3. Working Capital:
An IPO provides the company with the capital necessary to run its business. This allows the firm to operate at high productivity and maintain a healthy cash flow.
This, in turn, provides the company with an efficient working environment and greater job security for employees.
4. Exit to Previous Investors:
This is another important reason companies prefer to have IPO’s. It helps them get rid of their previous investors who invest at the time of incorporation by providing them with an opportunity to sell out.
5. Increasing market visibility/Brand awareness:
Many large companies use an IPO as a tool to increase their market visibility and strengthen their brand awareness.
Note: “When the company needs more money, they apply for an IPO.”
IPO Process in the Share Market:
If you understand how the Initial Public Offering (IPO) process in the share market works, you are better prepared to understand the basics of investing.
There are eight significant steps to the IPO process of issuing new stocks. They are;
- Hire an Investment Bank or Merchant Bank
- Due Diligence
- Filings
- Pricing
- Distribution
- Application Process
- Share Allotment
- Listing
All the above 8 steps are briefly discussed below:
Let’s understand all these steps with the help of an example. Let us say an electric bike manufacturer, ABC Ltd., has decided to launch its IPO on the market.
Step 1: Hire an Investment Bank or Merchant Bank:
Firstly, any company that decides to launch its IPO will hire a merchant bank or investment bank. Here, ABC Ltd. will hire the investment bank.
The primary function of a merchant bank or an investment bank is to help the company in every possible way.
He may also provide legal assistance and give advice on which shares will be the best for sale and at what time and at what price they can be sold off.
Step 2: Due Diligence:
An Investment Bank or Merchant Bank is responsible for the Due Diligence process.
It involves understanding the company thoroughly by studying all its financial statements, i.e., the P&L account, the balance sheet, and other supplementary information like how it has performed in the past, etc.
It also involves identifying all possible things that may go wrong and problems that may arise from time to time.
The two essential components of due diligence are:
- Underwriting
- Red Herring Prospectus (RHP)
(a) Underwriting:
Underwriting is like an agreement between the Investment Bank and the company.
The Underwriting Agreement states that the Investment Bank will buy the company’s shares for a specific price at which he can sell them on behalf of the company.
If the issue has a loss, then the Investment Bank has to bear the loss and vice versa. This means the Investment Bank takes responsibility for all liabilities related to the issue.
(b) Red herring prospectus (RHP):
RHP is the initial draft or document created by an investment bank containing information like company profile, business & promoter details, risk factors, financial statements, plans, management discussion and analysis (MD&A), etc.
Step 3: Filings:
The Investment Bank then submits the Red Herring Prospectus to all regulatory authorities like the Reserve Bank of India, Securities, Exchange Board of India, etc.
The Investment Bank is also responsible for compliance with all the guidelines and rules made by the authorities like SEBI, NSE, BSE, etc.
Step 4: Pricing:
Pricing is an essential step for an IPO. This step involves deciding the valuation of the company and then deciding on the price of the stock.
The Investment Bank will shortlist specific criteria about the company, which is to be kept in mind while pricing the IPO.
The company’s performance, reach, quality of management, growth prospects, etc., are some of the factors considered while deciding how much to charge for each share.
Step 5: Distribution:
After deciding on pricing, the investment bank will take care of the distribution of the issue.
It includes reaching out to large financial institutions like mutual funds, insurance companies, etc., and retail investors.
As per the norm, large investors are given more preference than medium or small investors.
Step 6: Application Process:
Finally, the applications are invited from investors. The subscription is open for a specific stipulated time.
For example: In the case of ABC Ltd’s IPO, it will be for 03 days.
After the stipulated time is over, the IPO closes, and allotment starts.
Step 7: Share Allotment:
The next step in the IPO process is an allotment. After receiving the applications, the investor who has applied for the shares will get a call from their investment bank either to confirm or decline their applications.
Hence, this process ensures transparency and fair allocation of shares by following certain norms.
Step 8: Listing:
After successfully executing all the 7 steps above, one must ensure the listing of new shares on stock exchanges like the BSE and NSE.
This is done by compliance with all regulatory norms, which generally has an extensive checklist of things to be done.
Benefits of Investing in IPO
Have you ever wondered what the benefits of an IPO are? There is an endless list of reasons people choose to invest in companies through initial public offerings (IPO).
Here are a few of the most popular benefits that IPO holders experience:
1. Investment opportunity
An IPO is a substantial investment opportunity for the countries’ citizens because it offers shares in the nation’s companies and insight into how their economy is faring.
People who buy shares usually make money if the company does well and its stock price rises.
They can either hold onto those stocks and wait for them to increase or sell them later for a more significant profit.
2. Diversification of holdings
An IPO can also provide investors with diversification in their portfolios.
New companies usually have more growth potential than established ones simply because they haven’t been around long enough to know their limits.
This makes Initial Public Offerings good options for investors looking to take advantage of this growth.
An IPO represents an opportunity to diversify one’s investment portfolio because the investor now owns a share of the company and its future profits.
3. Potential for High Return on Investment
IPOs are always considered high-risk/high reward investments because the stock prices are likely to increase dramatically.
The prices were initially low because the company is still growing. As the demand for the stock increases, so will the price.
The higher potential return on investment attracts many investors to buy shares in IPO companies.
4. Open investment
An IPO is also called open investment for common people to invest in companies of their own choices.
An investor can get an opportunity to buy shares, which were earlier out of reach because they were reserved only for the institutional investors (investors like insurance companies and pension and mutual funds).
5. Greater Transparency
Companies are required to publish financial information, business details, and other helpful information to conduct an IPO. This often has greater transparency.
This allows investors to form more informed decisions about whether or not they should invest.
Disadvantages of Investing in IPO:
The disadvantages of investing in IPOs are as follows:
1. Risk of Market Fluctuation
An IPO is a one-time chance to invest in an organization, with the risk of losing money due to market fluctuations or value deviation.
When investing in IPOs, there is always a risk that the market may fluctuate. This means that the value of shares can rise or fall unpredictably.
2. Decreased Consumer Sentiment
Once a company goes public, there is no guarantee that it will continue to satisfy customers like it did when they were privately owned.
If a company fails to maintain the same level of service after their IPO, consumer sentiment could decrease, and share prices would likely suffer.
3. Difficulty in determining Fair Market Value
In terms of the price of an IPO, sometimes there may be a large gap between what a company deems its value and what investors think it is worth.
This can lead to the investor’s inability to determine a fair market value for stock at first glance.
The market value of shares can only be determined once the company has begun trading publicly.
4. Marketability Risk
The risk that a stock may not find a buyer when required is known as marketability risk.
This type of risk can be exceptionally high in small or new companies and is generally more prevalent when the company’s financial status is not known or lacks transparency.
5. Not a Guaranteed Investment
IPOs are not guaranteed investments. There is no guarantee that an IPO holder will get an inevitable return.
The IPO holder could make or lose money based on how much the public company’s stock rises or falls in value after the stock has started trading on the market.
Tips for Successful Investment in IPO Shares
Before investing in shares of a new IPO company, here are few things to consider:
- Do your research on the issuer; check for analysts’ reports, financial numbers, etc.
- Read the prospectus; it includes all of the details, such as how the money will be used and the risk factors, as well as financial statements and forecasts.
- Before making a purchase, do your research to ensure that you are comfortable with the company and its products.
- Another important factor to consider before investing in an IPO stock is the industry of the company itself. From app developers to restaurants, there are many different types of businesses one can invest in. Each type has its risks and rewards; some industries are more volatile than others depending on supply and demand, so investors should consider this before investing.
- Investors must also consider what percentage of a company they wish to hold and whether or not the share price is reasonable at present. For first-time investors, a rule of thumb may be that if a company’s product does not hold much value in the market, then the IPO share price does not hold much value either.
- Buy stocks from companies similar to those in which you already invest.
- Research past IPO prices for this type of issuer as these factors can affect the current price.
- Be aware of what insiders (founders, management, etc.) are doing; if they buy big stakes on opening day, this is usually a good sign.
- Don’t assume that buying an IPO is “safe” because it’s a big-name company.
- Keep an eye on the company’s business plan and future goals.
Remember: Investing is full of risks, so never invest more than you can afford to lose. You might lose your initial investment. However, there are also chances that you get a very high return on it.
FAQS on What is IPO in Share Market
(Q1) What is an IPO in the share market?
(A) An initial public offering, also known as a stock market debut or simply an IPO, is when a company goes public and issues shares for the first time.
(Q2) Is it necessary for any company to do an IPO before they can start business operations?
(A) No. A company may start operations without doing an IPO.
(Q3) What is a prospectus?
(A) The prospectus is an official document that gives more information about the company’s IPO to the investor, which helps them decide if they want to participate or not.
(Q4) Why would anyone invest in an IPO?
(A) Investing in an IPO offers the potential for early growth, high returns, access to exciting companies, liquidity, and diversification opportunities.
(Q5) What are the risks of investing in an IPO?
(A) Investing in an IPO carries risks such as volatility, uncertain performance, lack of historical data, regulatory and legal risks, market conditions, and potential difficulties in accessing shares at the offering price.
(Q6) Why would some people choose not to participate in an IPO?
(A) Some people may choose not to invest because they feel that it is too risky or the stock price is overpriced.
(Q7) How does one find out when a company is planning to have its IPO?
(A) Most companies that plan to do an IPO will be featured in major newspapers, brokers’ websites, or they may choose to inform investors directly.
(Q8) How does one buy shares in an IPO?
(A) To invest in a company doing an IPO, you usually need to be part of the “distribution.” You can do this by going through a broker or your financial advisor.
(Q9) What is the primary purpose of having an IPO?
(A) The primary purpose of an IPO is to raise money for the company.
Conclusion
I hope this blog post has helped you understand what is IPO in share market and why it is necessary for a company to go through the process of becoming publicly traded.
Investment in the share market has always been a risky and profitable endeavor.
The more you know about an IPO investment, the better equipped you will be when deciding whether or not to invest your hard-earned money into these shares.
If you have additional questions about IPOs, please comment below. I will be happy to answer your questions.
Disclaimer : This article is for educational purposes only and should not be considered as financial or career advice or a recommendation of any kind. The author of this piece does not guarantee its accuracy. Always consult a financial advisor and do your research before trading or investing in any market! The author shall not bear any responsibility whatsoever for losses that may be incurred by trading. Trading and investing can involve a significant risk of loss, and it is not suitable for everyone.
