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What is an IPO (Initial Public Offering)? - Know in detail

Created on 29 Dec 2020

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Updated on 07 May 2024

What is an IPO (Initial Public Offering)?

If you have been following the stock market this year, you probably have encountered the term IPO a lot. For regular investors, this term is quite common, yet each time it comes up, it brings a spark of excitement with it.

If you are a beginner in the stock market, you might wonder why that is; each time an IPO is announced, it is all the finance media can talk about and why the investor circle gets all pumped up during some IPOs.

In the last few months, you might have noticed major IPOs like Tata Technologies and Bharti Hexacom Ltd. and also heard of some of the best upcoming IPOs like Swiggy.

So, returning to the major question here: What is an IPO, and what is all the hype about?

Let’s get into it.

Initial Public Offering: Definition

An IPO (Initial Public Offering) is the process through which a private company goes public by offering its stock to the general public. The company raises capital by publicly issuing its shares.

The company that offers its shares is referred to as an “issuer.” The issuer offers its shares with the help of an investment bank. After the IPO, the company's shares are traded in the open market. 

Why Do Companies Go Public?

There are a multitude of reasons why a company choose to raise funds via public offering. Here are a few of them:

  • To raise capital: An IPO brings immediate cash from the stock sales for a company, its promoters, and investors like angel investors and venture capitalists.
  • Long-term benefits: A publicly traded company can make an all-stock or cash-and-stock bid for another company it wants to acquire instead of an all-cash bid, which may require heavy borrowing. Stock and options are considered much more valuation incentive compensation, which allows a public company to attract and retain talents in the firm.
  • Cachet: An IPO brings prestige to a company. A listed company is regarded as more reliable to counterparts, lenders, and investors.

What Do IPOs Mean to the Economy?

The number of IPOs issued can also suggest the health of the stock market and the economy.

During a recession, IPO listings are dropped because the market price is undervalued. On the other hand, a huge number of IPO listings means that the economy and the market are getting back on track.

The IPO Process

The IPO process happens in five steps: 

1. Selecting the Lead Investment Bank

The IPO process starts with the promoters selecting a lead investment bank. This process generally occurs six months before the IPO. The applicant bank submits bids detailing the IPO result and the bank fees. The company selects the investment bank based on its reputation, quality of research and expertise in the market. 

The company wants an investment bank that can sell its shares to a maximum number of banks, institutional investors, or individuals as per the requirement. It’s the investment bank’s responsibility to put together all the buyers. The bank selects a group of banks and investors to raise IPO funding and also diversifies the risk. 

The investment bank charges a fee between three to seven per cent of the IPO’s total sales price.

This process of an investment bank handling an IPO is known as “underwriting”. Once chosen, the investment bank and company write the underwriting agreement detailing the amount to be raised, the type of securities to be issued and all other fees. 

2. Due Diligence

The next step of the IPO process is due diligence and regulatory filings, which generally happen three months before the IPO. The IPO team, consisting of the lead investment banker, lawyer, and other specialists, prepares the due diligence and assembles all the required financial information.

The investment bank files the registration statement with SEBI. This statement includes the financial statement, management background, and any legal problems. It specifies the purpose of the IPO, where the raised money will be used, and the current owners of the company. It also shows the company’s working model and other related factors.

SEBI will then investigate the company. It will ensure that all the information disclosed by the company is genuine and in the interest of the investors.

3. Pricing

The third and most crucial step of the IPO process is pricing. It depends upon the value of the company, the current situation of the market, and the economy.

After SEBI’s approval, SEBI and the company set up a date for the IPO. The underwriter circulates the prospectus, which includes all the company's financial information, and shares it with potential investors.

The company writes transition contracts for vendors. It also completes the financial statement for submission to auditors.

Almost three months before the IPO, the board of directors meet and review the audit. The company then joins the stock exchange that will list its IPO.

In the final month, the company files its prospectus with the SEBI and issues press notes announcing the shares' availability to the general public.

Generally, on the day of the IPO, the company’s head visits the BSE or NSE for the first day of trading and often rings the bell to open the market.

4. Stabilisation

The fourth step of the IPO process is stabilization. It happens just after the IPO. The underwriter creates a market for the stock after it has been issued. It ensures that there is a good number of buyers to keep the stock at a reasonable price. It lasts for 25 days, which is the “quiet period”.

5. Transition

The fifth and final stage of the IPO process is the transition to the open market competition. It starts after the quiet period ends. The underwriters provide approximate company’s earnings, which helps the investors as they transition depending upon the public information about the company.

Inside investors are free to sell their sales after six months of the IPO.

Advantages of IPOs

Here are the best outcomes of raising funds via an IPO:

  • An IPO usually suggests that the company is doing well enough to raise more capital to grow more. The raised capital helps in investing in a new project, acquiring new infrastructure, and paying off debt.
  • A company's shares can also help in mergers and acquisitions. The company can offer its shares as a mode of payment for acquiring another business.
  • An IPO helps a company hire the best-talented people in management. Additionally, it can hire employees at lower wages by offering share options during the IPO.
  • The promoter’s investment value increases many folds during the IPO, which pays off their hard work.

Disadvantages of IPOs

Among the good things, there are a few shortcomings as well:

  • The IPO process is very costly for the company. The leader of the company pays more attention to the IPO, which may affect the company's operations. Investment banks also charge a hefty fee for their services.
  • Original owners may not be able to sell their shares just after the IPO, as this could reduce the share price of the company.
  • The business control goes to the board of directors, which the original owner may or may not be a member of. In adverse conditions, the board of directors also has the power to fire the original owner of the company.
  • The company has to work under the strict scrutiny of the SEBI. 
  • A lot of details about the company go into the public.

The Bottom Line

There is a lot of excitement in the market when a company goes public. So, when an IPO occurs, investors tend to get excited with the thought of earning a quick return and making a good amount. It might also happen that the investors may lose their money quickly just after the IPO takes place.

Investing in an IPO involves taking a chance on a firm. Investors may favour it or deem it overvalued.

However, a prudent investor will examine the company’s prospectus and management team in detail. This will improve the chance of investors bidding for the best IPO and earning a good amount of money quickly.

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Sugar, spice & everything nice, that's what Pratiksha is made of. This proactive human makes difficult things look easy through her amazing skill of managing everything, be it professional or academic. Let’s not forget how this “Potterhead” makes room for her ‘occasional writing’ hobby while she leads marketing activities at Finology. 

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