What is an IPO?

You may have often come across that a certain company has decided to launch an IPO. Be it in the newspapers or during your watercooler

conversations with your office colleagues, you may have heard about the term IPO.

To throw in a number, as many as 163 companies launched an IPO in 2017 alone! Companies as big and diverse as Reliance, Coal India and ICICI have taken the IPO route in the past.

In this section, we will cover:

• IPO: Meaning
• Need for an IPO
• Why businesses opt to launch IPOs
• Primary market
• Secondary market
• Difference between primary and secondary markets
• How IPO investing is different from stock market investingv
• Who can invest in an IPO
• Recap

What is IPO?

So, let’s first understand what an IPO is. Just to initiate you, it is an abbreviation of initial public offering.

When you read that a company is launching an IPO, it means that a private business has decided to issue shares to the general public for the very first time.

Basically, this is the time when a private business decides to go public and get listed in the stock exchanges.

But, what is the need for an IPO?

You need money to meet your various needs. It’s no different for a business. Just like us, businesses need money to meet various needs. An initial public offering (IPO) is one of the avenues available to them to raise capital.

The bottom-line is this: Money is the bloodline of any business.

(Read more: What is an IPO?)

Consider these two instances:

Scenario 1: A 75-year-old garment manufacturing company operating in Tirupur, Tamil Nadu, needs to get into the branded apparel business. The company has years of expertise behind it but needs to build a brand. Extensive marketing and promotions have to be taken up urgently.

Scenario 2: A newsprint company in Indore, Madhya Pradesh, is desperate to shed its line of business and get into logistics. The prospects are good, especially in the booming e-commerce space.

(Read more: Why companies need capital)

So, how can these companies get more money?

These companies can borrow from banks. But what if they have borrowed a lot already? Will the banks still extend them loans?

Businesses can also take the IPO route. The IPO recourse can be even more attractive when the markets are on a high.

(Read more: Why invest in IPOs?)

When do companies need an IPO?

They may need an IPO to meet working capital needs. Working capital is needed to run the business. Companies also make use of IPOs by getting into new ventures, expanding operations and buying new equipment.

(Read more: Why companies go public)

Advantages of IPOs

• No repayment period is needed, unlike for loans offered by banks and financial institutions.
• There is no need to pay interest on the capital raised.
• The funds raised can be used to pay off old debts.
• Awareness about a company increases when it goes for an IPO. Since the shares are publicly traded, its products and services are also discussed in detail. This often leads to successful brand building and a better market share for its products.
• IPOs give investors an exit route. Several venture capitalists have exited a company after selling off their stake in the firm. Once the shares are publicly listed following an IPO, the prices often shoot up. So, the promoters and investors could become rich when they decide to sell off their stake.
• Whenever a company becomes publicly listed, it is bound by a regulatory framework. This framework helps prevent fraud. It is enforced by the market regulator Securities and Exchange Board of India (SEBI). The accounting practices of a company may become much more transparent following these practices. This transparency may benefit the company in the long run.

(Read more: What are the benefits of IPO investing?)

Where do companies launch their IPOs?

The transactions take place in a specific part of the capital market: that part is the primary market. This is also where you get to invest in the IPO.

Since private businesses issue new securities to sell to investors, the primary market is also called the new issue market.

How do businesses raise funds in the primary market?

There are four common ways:

• They can sell securities to the public through a public issue.
• They can offer new securities to existing shareholders through a rights issue.
• They can approach institutional investors through private placement.
• They can sell securities to select investors through preferential allotment. (In this case, the price of the security may or may not match its market value.)

In all these scenarios, the transaction is between:

• The business entity and
• The investor.

On receiving the sale proceeds, the entity will issue security certificates to the buyers. (Read more: What do companies do with the IPO money)

Keep in mind that many businesses approach large institutional investors during IPOs. In such a case, small investors may not be able to buy securities through the primary market. However, once the securities have been sold, they can be traded freely on the secondary market. (Find out how IPO shares start trading in the secondary market)

What is a secondary market?

Here, the trade in securities occurs via a stock exchange. Instead of the issuer, the current holder of the security sells the security to a new buyer. The seller typically aims to sell the security at a price that is higher than his purchase price. (Find out how IPO shares start trading on the secondary market)

The secondary market can be of two types:

• An auction market is a physical location where buyers and sellers gather. They state the rate at which they are willing to buy or sell the securities. All the information is public. As an investor, you can take a call accordingly.
• In a dealer market, the trade happens electronically (e.g. through fax or telephone). Here, a dealer serves as the middleman and carries a security inventory. He aims to make a profit on the transaction. So, you may need to shop around to get the best prices.

That’s not all. How you invest in both the markets also differs. Let’s read that next.

How does IPO investing differ from regular stock investing?

#1: The players

The seller: On making a successful bid in an IPO, you buy the allotted securities directly from the company that issues those securities. In regular stock investing, you buy shares from existing shareholders. Should you wish to sell shares that you already own, you can do so as well.

The go-between: While there is no middleman in an IPO, the regular trade in stocks happens through an intermediary agent (such as a stockbroker).

• Tip: Check that your intermediary agent is registered with the Securities and Exchange Board of India (SEBI) or recognised stock exchanges. This will help you safeguard your investments.

#2: The location

An IPO takes place on the primary market. It marks the first time that a company makes its shares available to the public for investment.

Regular stock investments happen on the secondary market. The shares belong to a company that is already traded on the stock exchange.

#3: The costs

When you invest in an IPO, the price (or a price range) is fixed. The amount is clearly mentioned in the company’s prospectus.

But the values of non-IPO stocks vary with the supply of and demand for those stocks. Current trends, inflation, the company’s growth prospects, and many other factors play a role.

(Find out why companies care about stock price)

#4: The assessment

To select an IPO, you should go through its prospectus and read third-party reports about the company. Then make your own informed assessment. Since the company has not been publicly listed yet, it may not have the detailed statements that are maintained by public companies. This lack of information can be a problem. But it can also prove a blessing.

Public companies maintain detailed paperwork to comply with SEBI’s strict guidelines. Working through this glut of information can be confusing for someone who is new to stock market investing.

(Read more: Thumb rules of investing in IPOs)

#5 Role of an underwriter

Underwriters play a very crucial role in the process of IPO listing. Underwriters are representatives of investment banks which are involved with the IPO. They perform due diligence, filings with SEBI, pricing, marketing, roadshows even eliminate any risk to the company or rather guarantee a certain amount of fund raised (if the agreement with the underwriter is bought deal).

In case of a bought deal the underwriter buys the entire lot of share at a highly discounted price, and resells the shares to its clients, public. Such an agreement will eliminate any risk for the company, however, the underwriter will take risk only in case the underwriter is sure to make a good spread in the deal.

Who can invest in an IPO?

There are different types of investors:

• Institutional investors - The underwriter will try and sell large chunk of these share to a handful of its institutional clients like insurance companies, mutual funds etc. at a lucrative price before the IPO. A lock – up contract with such institutional investors varying from 90-180 days ensures minimal volatility on the day of IPO.

  As a general rule, 50% of allocation of share is to these institutional investors and is completely discretionary.

• High net worth individuals (HNIs) – Individual investors looking to invest more a value of more than INR 200,000 are categorized as HNIs. The allotment of shares to HNIs is proportionate and falls under 10 – 15%.
• Retail investors – The class of investors subscribing in an IPO for a value of INR 200,000 or less fall under this category. The probability of getting an allotment is higher under the retail quota as SEBI has designed the allotment method in a way that maximum retail investors are included. Allocation under the retail quota is nearly 35%.

  Basically, any adult competent enough to enter a legal contract can invest in an IPO. Essentially, one must have a Permanent Account number (PAN) issued by the Income Tax department and a valid demat account.

  Trading account is a mandatory requirement, in case one intends to sell the stock on listing. It is therefore advisable to have a demat cum trading account, Kotak securities offers one such account <link>, making investing in an IPO hassle free.

A quick recap

• An IPO, or initial public offering, takes place when private businesses decide to issue shares in the primary market for the first time. The reasons for taking the IPO route are manifold. Some of the common reasons are: money needed to expand operations, repay debt, initial investors looking to sell their shares and getting into new ventures.
• There are several benefits of issuing an IPO. Not paying interest on the capital raised and not having a deadline to repay a bank loan are some of the strong reasons why businesses choose the IPO option.
• There are basic differences while investing in an IPO and putting money in existing company stocks. The costs involved and the assessment required are some of the factors that differentiate the two types of investing.

What next:

Now, you know why companies go for IPOs. The next question is: What is in it for you? Why invest in IPOs? <Learn it for yourself by clicking here>