How Does an IPO Work

An initial public offering (IPO) marks a company's transformation from a privately held company to a publicly traded one, allowing investors to buy and sell shares on a stock exchange. IPOs allow companies to raise capital for growth and expansion while enabling investors to participate in the company's success. So how does an IPO work? Let's find out.

IPO Working Process

Before initiating an IPO, a company must comply with various regulatory requirements. The company must demonstrate strong financial performance, have a sound business model, and meet specific listing criteria. Once done, it involves the following processes:

1. Hiring of an Underwriter or Investment Bank

The IPO process requires a deep analysis of the company's financial parameters, which is within the purview of financial experts. The underwriters from the investment bank oversee the entire IPO issuance and act as intermediaries between the company and its prospective investors.

These experts also evaluate other critical parameters of the company and execute an underwriting agreement that encompasses the following components:

• Providing details of the deal
• Determining the amount to be raised
• Specifying the details of the securities being issued

2. IPO Registration

Every company must comply with the Indian Companies Act by preparing and issuing an IPO registration statement, including a draft prospectus known as a Draft Red Herring Prospectus (DRHP). The prospectus serves the purpose of providing investors with the following information:

• The company's financials, including risk factors that may impact them
• The aim of raising capital through disclosure of the use of proceeds
• An industry description to outline the relevant industry segment and factors that can affect the company
• Clarity on the company's business operations
• Key people within the management and their details
• Financial statements, along with the auditor's report, are listed to present the company's financial position
• Legal and miscellaneous information to outline any litigation and other relevant details

3. Verification by SEBI and Stock Exchange Application

Once the company submits its registration statement and the DRHP to the registrar, it can formally apply for an IPO with SEBI. Later, SEBI verifies the company's disclosure of facts. If SEBI approves the application, the company can announce an IPO date. Post SEBI's approval, a company applies to stock exchanges for floating its IPO issue.

4. Marketing

Once the company finalizes the IPO issue, it can initiate marketing efforts for its issue. These efforts may include social media marketing, conducting roadshows, placing advertisements, and more. The primary objective is to maximize the subscription of the issue by attracting as many investors as possible.

5. IPO Pricing and Bidding

The company consults investment bankers to finalize the price of each share before its IPO goes public. This can be done through either a Fixed Price IPO or a Book Building Offering. In a Fixed Price Offering, the company announces the price of its stocks in advance. In the case of a Book Building Offering, a price range of 20% is announced. Investors can place their bids within that price bracket.

In the bidding stage, investors place bids according to the company's quoted lot price. The booking typically remains open for three to five working days, allowing investors to revise their bids during this period. Once bidding concludes, the company determines the cut-off price, which represents the final rate at which the issue is sold.

6. Share Allotment

After the IPO concludes, the company, in collaboration with the underwriters, determines the allocation of shares to each applicant. In the case of oversubscription, where the demand for shares exceeds the available supply, applicants receive partial shares within 10 working days. Also, in such scenarios, the company must devise a fair and equitable method to allocate shares to the applicants.

Eligibility Criteria for Companies for IPO

A company is eligible for IPO if it satisfies the following criteria:

• The company must be at least 3 years old and maintain its registered business status for over 3 years.
• A company's net worth on a consolidated basis should have been a minimum of ₹1 crore for each of the past 3 years
• A firm's net tangible assets should have been around ₹3 crores for each of the past 3 full years, with no more than 50% in cash or cash equivalent
• The total net asset value of ₹3 crore should be derived from non-cash assets
• There should be no default on any loan or credit line on behalf of the company
• The value of the company's total issue size should not exceed 5 times its net worth before issuing an IPO
• If a company has adopted a new name, at least 50% of its total revenue earned in the last year should be generated after the incorporation of this new name
• The company must have an average operating profit of a minimum of ₹15 crores calculated on a consolidated basis for the previous 3 years annually

In Conclusion

An IPO offers companies the opportunity to raise capital and grow their businesses while investors can participate in the success of these companies. Understanding the IPO process is essential for investors to make informed decisions and navigate the dynamic stock market. By following the steps, you can better understand how IPOs work and be better equipped to make investment decisions in the future.