What Is IPO - Here's Everything You Must Know!

10 mins read

Investing in the stock market can be an exciting opportunity, and one of the most anticipated events for investors is an Initial Public Offering (IPO). Companies use IPOs to transition from private ownership to publicly traded entities, offering shares to the public for the first time.

This article explores the concept of IPOs, their workings, pros and cons, historical relevance, and more.

What Is an IPO?

An Initial Public Offering (IPO) is the process through which a private company offers its shares to the public for the first time. This transition allows businesses to raise capital from public investors in exchange for partial ownership in the company.

History of IPOs

The concept of publicly traded shares can be traced to the early 1600s. The Dutch East India Company is often credited with conducting the first modern IPO in 1602. They issued shares to the public, marking a significant development in financial history.

19th Century Growth: In the 19th century, particularly in the United States, IPOs played a crucial role in financing the construction of major infrastructure projects, such as railroads.

Modern Developments: The 20th and 21st centuries have seen the IPO market evolve significantly, with increased regulation and technological advancements.

In India, the development of the IPO market is closely tied to the growth of its stock exchanges and the liberalization of its economy. The establishment of SEBI played a vital role in regulating and promoting IPO activity.

Types of IPO

Companies can choose different types of Initial Public Offerings (IPOs) based on their financial needs, regulatory requirements, and market conditions. The main types of IPOs include:

1. Fixed Price IPO

In a Fixed Price IPO, the company sets a predetermined price for its shares before the public offering. Investors know the price in advance and must subscribe accordingly.

Key Features:

• The price is decided based on company valuation and market conditions.
• Investors must pay the full amount when applying for shares.
• Demand is revealed only after the issue closes.

2. Book Building IPO

A Book Building IPO allows investors to bid for shares within a specified price range (floor price and cap price). The final share price is determined based on demand.

Key Features:

• Investors place bids within the given price range.
• The final price is decided through investor demand.
• Provides a more market-driven pricing approach.

3. Green Shoe Option IPO

A Green Shoe Option IPO includes a provision where the company can issue additional shares (usually up to 15%) if demand exceeds expectations. This helps stabilize the stock price post-listing.

Key Features:

• Used to prevent excessive price volatility.
• Increases supply if demand is high.
• Provides flexibility to underwriters.

4. Dutch Auction IPO

In a Dutch Auction IPO, investors place bids for the number of shares they want and the price they are willing to pay. The company sets the final price at which all shares are sold, based on the highest demand.

Key Features:

• Investors bid for shares at different price points.
• Ensures fair price discovery based on demand.
• Used by companies like Google for their IPO.

5. Hybrid IPO

A Hybrid IPO combines elements of both Fixed Price and Book Building methods, allowing a portion of shares to be offered at a fixed price while the rest follows a book-building process.

Key Features:

• Provides flexibility in pricing strategies.
• Attracts different types of investors.
• Balances demand-driven pricing with predetermined valuation.

Each type of IPO has its advantages and is chosen based on the company's strategy, investor interest, and market conditions.

IPO Process

Here is the step-wise process of how an IPO is worked up: 

Step 1: Selection of Underwriters

The IPO process begins with a company selecting investment banks or financial institutions to act as underwriters. These underwriters play a crucial role in structuring the IPO, managing risks, setting the price range, and ensuring the offering reaches the right investors.

Key Responsibilities of Underwriters:

• Assessing the company’s financial health and future growth prospects.
• Advising on the type of IPO (fixed-price or book-building).
• Determining the number of shares to be issued and their pricing range.
• Preparing necessary documentation and compliance reports.
• Managing risk by purchasing shares if demand is low.

Companies often choose a syndicate of underwriters to distribute the risk and leverage a larger investor network.

Step 2: Regulatory Approval

Before an IPO can proceed, the company must obtain regulatory approval by submitting financial and business-related documents to the appropriate authorities.

Key Regulatory Filings:

• Draft Red Herring Prospectus (DRHP): A preliminary document outlining business operations, risks, financials, and intended use of IPO proceeds.
• Final Red Herring Prospectus (RHP): The final version with confirmed details after regulatory feedback.
• SEBI (or SEC) Approval: In India, the Securities and Exchange Board of India (SEBI) reviews filings to ensure investor protection. In the U.S., the SEC (Securities and Exchange Commission) performs this role.

Regulatory authorities may request modifications, and only after approval can the company proceed to the next step.

Step 3: Roadshow & Marketing

To generate investor interest, the company and underwriters conduct a roadshow—a series of presentations and meetings with institutional investors, fund managers, and analysts.

Objectives of the Roadshow:

• Present the company’s financials, business model, growth potential, and competitive advantages.
• Address investor concerns and answer questions about risks.
• Gauge investor demand, which helps in finalizing the IPO price.

The company also uses media campaigns and advertising to create buzz among retail investors.

Step 4: Pricing the IPO

Based on investor demand during the roadshow, the company, along with the underwriters, determines the final IPO price. There are two common pricing methods:

1. Fixed Price Method: The company sets a predetermined share price before the IPO.
2. Book Building Process: Investors bid within a price range, and the final price is determined based on demand.

The issue price should strike a balance between maximizing capital for the company and ensuring post-listing gains for investors.

Step 5: Allotment & Listing

Once the IPO price is set, shares are allotted to different categories of investors, including institutional investors, retail investors, and high-net-worth individuals.

Allotment Process:

• If demand exceeds supply, shares are allocated through a lottery system or proportionally reduced allotments.
• If demand is low, underwriters may step in to purchase unsold shares.

Finally, the shares are listed on the stock exchange, and trading begins. The first trading day often sees significant price movements based on market demand.

Pros and Cons of an IPO

The common pros and cons of IPO include: 

Pros:

• Capital Raising: Companies raise funds for expansion.
• Increased Visibility: Public trading enhances brand recognition.
• Liquidity for Shareholders: Existing investors can sell their stakes.

Cons:

• High Costs: IPOs involve hefty underwriting and compliance costs.
• Regulatory Scrutiny: Public companies must disclose financial details regularly.
• Market Volatility: Share prices fluctuate based on market conditions.

Investor Tip: Before investing, analyze the company's fundamentals, industry outlook, competitive edge, and valuation to make an informed decision.

IPO Alternatives

When a company seeks to raise capital or go public, the traditional Initial Public Offering (IPO) is a well-known route, but it's not the only one. Here are some key alternatives:

• Direct Listing: Instead of issuing new shares, a company's existing shareholders sell their shares directly to the public. This avoids the traditional underwriting process.
• Reverse Merger (or Reverse Takeover): A private company acquires a public "shell" company, effectively becoming public without going through a traditional IPO.
• Private Equity or Venture Capital: Companies can raise capital from private investors, such as private equity firms or venture capitalists, without going public.
• Debt Financing: Companies can borrow money through loans or bonds, rather than issuing equity.
• SPACs (Special Purpose Acquisition Companies): These "blank check" companies raise capital through an IPO with the purpose of acquiring an existing private company, thus taking that private company public.

Performance of an IPO

The performance of an IPO varies depending on multiple factors, including market conditions, company fundamentals, and investor sentiment. Some IPOs witness a significant price surge on listing day, while others may struggle to maintain their offer price.

Factors Affecting Performance

• Market Sentiment: Bull markets often lead to high IPO demand, while bearish conditions can dampen enthusiasm.
• Company Fundamentals: Strong financials and growth potential drive sustained post-IPO performance.
• Industry Trends: Tech IPOs often receive more attention compared to traditional sectors.
• Valuation & Pricing: Overpriced IPOs tend to struggle post-listing, while well-priced ones attract investors.

Why Would a Company Do an IPO?

An Initial Public Offering (IPO) allows a private company to go public by offering its shares to investors. Companies opt for an IPO for several strategic and financial reasons:

1. Raise Capital for Growth

An IPO provides companies with substantial funds that can be used for:

• Business expansion (new markets, product development, infrastructure).
• Research and development (R&D) for innovation and competitiveness.
• Debt repayment to improve financial health and reduce interest burdens.
• Acquisitions and mergers to strengthen market position.

2. Enhance Credibility and Market Reputation

Publicly traded companies are subject to regulatory oversight, financial disclosures, and governance standards, which:

• Boost investor and stakeholder confidence.
• Improve access to future funding through stock offerings or bonds.
• Enhance brand visibility and credibility in the industry.

3. Allow Early Investors and Employees to Exit

An IPO enables:

• Initial Investors (VCs, Angel Investors, Private Equity firms) to sell their shares and realize profits.
• Founders and Early Employees to monetize their equity holdings through stock sales.

4. Offer Liquidity to Shareholders

Public listing creates an open market where existing shareholders can trade shares, improving liquidity and price discovery.

5. Facilitate Employee Stock Ownership Plans (ESOPs)

Going public allows companies to issue stock-based compensation, attracting and retaining top talent.

Who Gets the Money From an IPO?

1. The Company (Primary Offering)

• The primary purpose of an IPO is securing funds for growth.
• If the company issues new shares, the capital raised directly funds business operations, expansion, or debt repayment.

2. Existing Shareholders (Secondary Offering)

• In some cases, pre-IPO investors (founders, early investors, venture capitalists) sell their shares during the IPO.
• The money from these sales does not go to the company but to the selling shareholders.

3. Underwriters & Brokers

• Investment banks and brokers managing the IPO earn commissions and fees for underwriting, marketing, and executing the offering.
• These costs typically range from 3-7% of the IPO proceeds, depending on the deal size.

An IPO is a significant event for both companies and investors. While it provides opportunities for growth and investment, it also carries risks. Investors should conduct thorough research and assess market conditions before investing in an IPO.

Quiz Time!!!

Frequently Asked Questions about IPO

1. How can I apply for an IPO?

Investors can apply through a broker or online banking platforms via ASBA (Application Supported by Blocked Amount).

2. Are IPOs always profitable?

No, IPOs can be volatile, and post-listing performance depends on market conditions.

3. Can retail investors invest in an IPO?

Yes, a portion of IPO shares is reserved for retail investors.

4. What is the lock-in period for IPO shares?

Promoters and anchor investors may have lock-in periods before they can sell shares.

5. How is the IPO share price decided?

The price is set through a book-building process based on investor demand.

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