Initial Public Offering - IPO Meaning, Working, Process and Types of IPO

Deciphering IPOs and the Primary Market

When you first start investing in the market, you are often bombarded with a slew of jargons. And, while it may appear difficult, a majority of it is simply related to understanding a company's structure and ownership.

A company, according to the classic definition, is an organisation made up of assets such as capital, infrastructure, and people. A business purchases inputs such as raw materials and labour, as well as rents or purchases infrastructure, in order to produce outputs in the form of goods and services. Companies can either be:

• Privately owned
• Publicly owned and traded

Private ownership of a company implies it being funded by private entities. A publicly owned company is one which is at least partly funded by the public and traded on share markets. A person or an institution that funds a company is part owner of the company and is allotted shares of the company, bestowing voting rights on the shareholder. So a company may be fully owned by a single entity, or multiple entities may own the company as part owners. The company appoints a board of directors based on the majority vote of the shareholders. The board of directors is empowered to make decisions on behalf of the company.

Along with understanding company structure and ownership, understanding the difference between primary market and secondary market is also crucial for investors looking to invest in IPOs. The primary market facilitates the initial sale of securities through mechanisms such as IPOs, whereas the secondary market ensures that these securities can be traded among investors post-issuance. This dynamic interplay between the two markets forms the backbone of capital markets, enabling companies to raise funds and investors to realise gains.

Primary Market vs Secondary Market

The primary market is where companies issue new securities to raise capital, offering shares directly to investors. This market is essential for enabling companies to finance new projects, expand operations, and innovate. In contrast, the secondary market deals with the trading of existing securities. Here, investors buy and sell shares among themselves, providing liquidity and helping to establish a fair market price.

The difference between primary market and secondary market lies in their functions and operations. While the primary market focuses on the issuance of new securities, the secondary market facilitates their continuous trading. This distinction is crucial for understanding how companies raise capital and how investors engage in trading activities.

What Is an IPO?

An Initial Public Offer, commonly known as IPO, helps a private company transform into a public company. Informed investors aim to earn returns on investments with an IPO after a careful analysis of the benefits and risks. To join the league, it is essential to understand the basics. The IPO meaning entails a company's transition from private to public ownership, allowing it to raise capital from a broader investor base. Understanding what an IPO is, is essential for investors looking to participate in these initial offerings and for companies aiming to raise funds through public investment.

Types of IPO

Book-building offering and fixed price offering are the most popular types of IPOs. In a book-building offering, bidding is involved since investors can bid before the enterprise decides the final price of shares. Generally, the company makes an offer of a 20% price band. The investors need to specify the amount they intend to invest and the number of shares they want to buy. Here, the highest share price is the cap price, and the lowest is called the floor price. The final call for the ultimate share price is considered based on the bids placed by the investors.

In a book-building IPO, let's say Company XYZ plans to go public with a price band of ₹20 to ₹24 per share. Investors can bid within this range. Investor A bids for 500 shares at ₹22 each, Investor B bids for 300 shares at ₹24 each, and Investor C bids for 200 shares at ₹21 each. The company reviews these bids to determine the final price, aiming to maximise the funds raised while ensuring strong demand. If the highest demand is at ₹22, the company may set this as the final price. Shares are then allocated to investors who bid at or above this price, meaning Investor A and Investor B receive their shares, while Investor C might not, depending on the company's allocation strategy. This process helps the company find the optimal price by assessing investor interest.

Contrastingly, in the case of fixed-price offering, the final price set by the corporation for the primary sale of their stocks. It is only known to the investors after the corporation decides to make it public. Investors willing to participate in the IPO must fulfil all the terms and complete the full payment during the application process.

In a fixed-price IPO, let's say Company ABC decides to go public and sets a fixed price of ₹50 per share. This price is announced to investors when the IPO is made public. Investors who want to buy shares must agree to purchase them at ₹50 each and complete the full payment during the application process. Unlike the book-building process, there is no bidding involved, and all investors pay the same fixed price per share.

Here’s a table to summarise the key differences:

Process of an IPO

The IPO process involves five key steps:

Preparation: The company works with investment banks to prepare for the IPO, including financial audits and regulatory filings.

Filing: The company files a prospectus with the regulatory authorities, detailing the financials, business model, and risks.

Pricing: The company determines the price of the shares through either the book-building or fixed price method.

Allocation: Shares are allocated to investors based on the demand and the chosen pricing method.

Listing: The shares are listed on the stock exchange, allowing them to be traded in the secondary market.

Common terms associated with an IPO

• Oversubscription: When the number of shares applied by the investors exceeds the number of shares offered by the company, it is called oversubscription.

• Under subscription: This is the opposite of oversubscription. When the number of shares applied are comparatively lesser than that offered by the enterprise, the condition is said to be under subscription of shares.

• Issuer: The company willing to go public by way of offering part of its holding to investors is said to be the issuer.

• Underwriter: Underwriters commit the issuing entity that the remaining stocks from the final pool of offers, if not picked up by investors, will be subscribed by them. Underwriters can be anyone like a broker, financial institution or banker. IPOs are beneficial to the issuing entity and the investors. It helps the enterprise build prestige and expand their exposure in the market apart from increasing the equity base. Investors must identify the right opportunities by understanding the financial metrics to yield solid returns from an IPO.

• Prospectus: A detailed document filed with regulatory authorities, offering insights into the company's financials, business model, and risks.

• Underwriter: An investment bank that assists the company in preparing for the IPO, setting the price, and selling the shares.

• Lock-up period: A specified period post-IPO during which insiders and early investors are restricted from selling their shares.

• Allotment: The process of distributing shares to investors based on the demand and pricing method.

• Listing day: The day when the company's shares are listed on the stock exchange and become available for trading in the secondary market.

• Price band: In a book-building IPO, this is the range within which investors can bid for shares, consisting of a floor price and a cap price.

• Red herring prospectus: A preliminary version of the prospectus that contains most of the information about the business but omits crucial details like the issue price.

• Greenshoe option: A provision that allows underwriters to sell more shares than initially planned, usually up to 15% extra, to stabilize the share price post-IPO.

• Flipping: The practice of selling shares immediately after the IPO to take advantage of short-term price increases, often discouraged by underwriters to maintain price stability.

Conclusion

Navigating IPOs requires a solid grasp of their processes and terminology. Understanding the distinctions between book-building and fixed-price offerings, along with key terms like prospectus and greenshoe option, enables investors to make informed decisions. As IPOs continue to shape the financial landscape, being well-informed allows investors to seize opportunities and manage risks effectively. This knowledge empowers investors to engage confidently and strategically in the evolving market.

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