There’s an old proverb which says – “The Journey of thousand miles begins with a single step”
Similarly, the journey of every public company in stock market begins with an IPO. Basically, a private company goes public through IPO process. So if you are planning to make an investment in the equity market, understanding the concept of Initial Public Offering (IPO) would be valuable for you.
Before we dig deep into the concept of IPO, it’s better to understand a brief distinction between private and public companies.
In a layman’s term, a public company is one whose shares are listed and traded on a stock exchange. The life of most companies starts as private companies.
A company in order to go public must get the necessary approvals and some portion of the shares is offered for sale to the general public. Soon after the successful completion of the IPO, the shares are ready to openly trade on an exchange.
What is an Initial Public Offer (IPO)?
Initial Public Offer (IPO) is a mechanism which enables private or unlisted companies to go public to raise funds for business expansion or to repay debt or for promoters to dilute stake in the company. IPO implies that company for the first time will financially benefit from the issue of its stock. However, after the IPO, the company will not receive any compensation but there will be the just transfer of shares between the buyer and seller in the open market.
The IPOs are generally introduced by the underwriting investment bank which helps the company in setting the price at which it will go public and also supports company in getting potential customers.
Read here: 15 Biggest Myths about Money and Investing
Reasons why a private company goes public
a. To raise money
Money is raised for a number of reasons which includes expansion plan, for working capital need, to make acquisitions, research & development etc.
b. To create liquidity for the early investors
IPO generally help to dilute the stake of existing shareholders and help to expand the customer base. Angel investors, senior management, venture capitalists and private equity investors who have been associated with the company from the beginning would like to cash in some profit.
c. To create brand and reputation
Reputation plays a key role in the business world. Listing on a reputed exchange like NSE or BSE adds to company’s reputation as the company is now under the guidelines of SEBI. Now it can attract better employees and able to raise funds easily due to the higher level of trust.
Soon after the company wants to go public, it hires the investment bank to manage the entire procedure. Further, both of them decide a number of funds to be raised, type of securities to be issued and other necessary details.
The underwriter then put everything in a document called red herring prospectus. This document contains all necessary details about the company except for the effective date and the offer price.
“ASBA” for subscribing to an IPO
ASBA stands for “Application Supported by Blocked Amount”. It’s an application mechanism for subscribing to IPOs. It ensures that money remains in the bank account unless the shares are allotted to the applicants. But the applicant is needed to give an authorisation to block the money while subscribing to the IPO.
Application Supported by Blocked Amount (ASBA) was introduced in the year 2008 for retail investors which have now been extended to corporate investors and HNIs from 1st January 2010.
The investor can apply for any public issue through their bank account under ASBA. From any designated bank branches, they just need to collect the ASBA form and fill necessary details like name, PAN number, demand number, bid price and quantity and other important details. Thereafter submit the form and instruct your bank to block the funds in his/her account. Make sure that everything is filled correctly, else it will be rejected.
What value of shares can an investor apply in an IPO and for what period does it remains open?
The upper cap on the investment value made in an IPO by a retail investor stands at Rs 2 lakh.
The IPO generally remains open for 3-7 days but the actual number of days it will remain open will be decided by the lead manager and the issuing company.
Checklist to invest in an IPO
These are the checklist you should look into before investing in an IPO-
- Conduct a background check on promoter’s capabilities
- To gain an understanding about the company’s scalability in the future, look for the projects the company has in its pipeline
- Look for the IPO’s issue size.
- Higher promoter stake is always considered good as it indicates a sense of responsibility on the part of promoters
Key terminologies in an IPO
Abridged Prospectus – Abridged prospectus contains all the key features of a prospectus. It accompanies the application form of public issues.
Follow on public offering (FPO)– FPO is when a listed company through an offer document either makes a fresh issue of securities or offer for sale to the general public.
Red Herring Prospectus – A red herring prospectus is a preliminary prospectus filed by a company with regards to company’s IPO. It contains important details with respect to company operations and future prospects but does not contain details of price or number of shares to be offered.
Book building process – It’s a process by which the underwriters attempts to determine the price at which the IPO should be offered based on the demand from the institutional investors.
Preferential issue – Preferential issue implies when the company issues securities to select group of people.
There are both benefits and demerits associated with an IPO. Simply betting on the listing gains will not be a good idea. Stay cautious when you plan to invest in a company which goes public at least for the initial few months as there’s no trading track record available. Moreover, the management also remains in the silent period until the quarterly earning comes in, where you can listen to management’s conference call and gain some clarity regarding their vision and future plans.
It’s always advisable to do a proper research before you invest in an IPO. Read red herring prospectus as it provides good insight into the company and the people managing the same