Chapter 5: Initial Public Offer (IPO)
5.1 Primary and secondary markets
In the primary market, the company issues securities directly to investors. This typically happens during an IPO or whenever a company wants to issue securities in the form of a bonus or rights issue.
In the secondary market, the transaction takes place directly between investors and the issuer is not involved. These transactions typically take place on the stock exchange.
5.2 Initial Public Offer (IPO)
An IPO (Initial Public Offer) is a process through which a company raises capital for the first time from the public by selling its equity. The company which offers its shares through the public issue is known as an 'issuer'. After the IPO, the company's shares are listed on the stock exchange and can be further traded by investors on the exchange.
Let us understand it in detail:
Assume that company ABC Ltd. is running successfully and is fully owned by its promoters. To expand, the company management decides to raise capital by issuing fresh equity shares to the public. The management decides to issue three crore shares of Rs. 10 to the public at a rate between Rs. 105 -110 per share. Here the face value of the share is Rs. 10 and they decided to charge Rs. 95-100 as a premium on these shares. If this issue is subscribed at the higher price band i.e. Rs. 110, the company will raise Rs. 330 crore. The premium charged by the company is due to profitability, brand, and growth prospects and based on the value of other peer group companies.
If you purchase a share of this company, you become a partial owner and will be known as a shareholder. If you purchase one share in this company, your stake in the company is equivalent to Rs. 10 not Rs. 110 because you have purchased a share worth Rs. 10 in Rs. 110. Alternatively, you can also find your stake by dividing the number of shares you own to total number of shares of the company.
5.2.1 Types of IPO
Generally, IPO is of two types: Book Building and Fixed Price issue. Most of the IPOs in current times are Book Building ones. The major difference between these IPOs is the price offered to investors. In Fixed Price issues, there is only one price and all investors need to apply at that price only. In a Book Building issue, there is a price band and investors have the option of bidding at any rate between the price bands. Let’s understand this better with the same example mentioned above.
In this case, the company is offering three crore shares in the price band of Rs. 105-110. Here, the lower price band is Rs. 105 and the upper price band is Rs. 110. Investors have the choice of bidding for this IPO in the range of Rs. 105-110. Based on applications received, the company will decide the issue price so that the IPO can be subscribed fully. In the case of oversubscription, allotment could be on a pro-rata basis. If the issue is highly subscribed, then allotment could also be on a lottery basis. Investors who have bid below the issue price will not get any shares, and investors who have applied at rates higher than the issue price will be allotted shares at the issue price only.
Many retail investors who may not be in a position to evaluate the correct IPO price, choose the option of ‘cut off-price’ to apply for an IPO. Cut off price means that you are applying for the shares at issue price without bidding at a specific value.
5.2.2 Types of investors for IPO
There are different types of investors:
Retail Individual Investors (RII)
Investors applying for shares worth less than Rs. 2 lakh in an IPO are considered as Retail Individual Investors (RIIs). RIIs have an allocation of 35% of shares of the total issue size in Book Building IPOs. NRIs who apply with less than Rs. 2 lakh are also considered in the RII category.
Non-Institutional Investors (NII) and High Networth Individuals (HNIs)
Individuals looking to invest more than Rs. 2 lakh are categorized as HNIs. Similarly, institutions that want to subscribe for more than Rs. 2 lakh are called non-institutional investors (NIIs). These investors need not be registered with SEBI like QIBs. This category of investors has an allocation of 15% in an IPO.
Qualified Institutional Bidders (QIBs)
Financial institutions, banks, FIIs, and MFs that are registered with SEBI are called QIBs. Normally, 50% of shares are allocated to QIBs in an IPO.
5.2.3 Common IPO terms
Issue subscription: This refers to the number of bids that were received for an IPO. Based on that number, an issue could be over-subscribed or under-subscribed.
Under-subscribed issue: - If the number of bids received for shares is less than the shares offered in an IPO, it is considered as an under-subscribed issue. It shows that the demand for shares is lower. If the issue is subscribed by less than 90%, it will be withdrawn from the market.
Over-subscribed issue: If the number of bids received is more than the shares offered, the issue is considered as over-subscribed. It shows that demand for shares of the company is high and bidders will get less than the number of shares applied for.
Green shoe option: This is an option that can be used by the issuer in case of over-subscription. Under this, the issuer can issue up to 15% additional shares in the IPO.
Cut-off price: This is the issue price decided by the issuer based on bids received during an IPO and remains between the price bands of a book building IPO.
5.2.4 IPO process
Appointment of Merchant bankers
Merchant bankers manage the entire show of an IPO and are important entities. Starting from due diligence, preparing the Draft Red Herring Prospectus (DRHP), and assisting the management in deciding the right price of the IPO to helping in advertising and subscription of the issue, they are involved in the entire process. They are also known as Lead Managers or Book Running Lead Managers (BRLM) of the issue.
IPO registration with SEBI
The company applies to SEBI with the IPO proposal, details of the company’s current financial health, objective of the issue, etc.
Preparation of DRHP
After getting a nod form SEBI, the company prepares the Draft Red Herring Prospectus (DRHP). It includes all necessary information related to the issue and the company. This will help investors know more about the company, its business, and the evaluation of the IPO.
IPO promotion, fixing of the price band
After completing all compliance formalities, the company starts promoting the IPO and decides the IPO price. The company also decides on the launch date, listing date, etc. After closing the issue, the allotment process is carried out and shares are ready to be listed on the bourses.
Listing of the share on the stock exchange
Listing of shares is a milestone for the company. Listing price can be more or less than the IPO, depending on demand/supply and market sentiments.
5.2.5 How do I invest in an IPO?
A demat account is a prerequisite to apply for an IPO. A demat account is an account for storing your securities in an electronic form. This account can be opened with a Depository Participant (DP).
You can also apply for an IPO through your trading account or bank account online. Alternatively, you can also apply for an IPO by filling up the physical form and submitting it to your broker.
All IPO applications are supported by ASBA (Application Supported by Blocked Amount) which eliminates the need for giving cheques or DDs along with your application. ASBA facility allows banks to block money in your bank account which will be debited after the allotment process is complete.
You need to bid while applying for shares as per the lot size mentioned in the prospectus. The lot size is the minimum number of shares you have to apply for during an IPO. Usually, there is a price band in an IPO and you can bid at any price in that band. The number of shares in a lot is decided based on the share price, so the value of a lot will be around Rs. 15,000.
Allotment is based on the demand for the issue in comparison to the number of shares offered by the issuer. If demand exceeds the number of shares offered, then you will get fewer shares than you asked for. Sometimes, there is also the possibility of no allocation due to huge over-subscription. After completion of the allocation process, shares will be credited to your demat account. After that, shares will be listed on the stock exchange within seven days.
You can get all IPO-related information and can apply for an IPO online on ICICIdirect.com under the IPO section.
5.2.6 FPO and OFS
In a Follow on Public Offer (FPO), an already listed company can again go to the public and issue fresh shares. The process is similar to an IPO and anyone can participate in it.
Offer for Sale (OFS) is used by companies to dilute the promoter’s stake. Generally, OFS is used to meet public shareholding requirements. In case of an OFS, the company does not issue any new shares; only existing holders sell their stake.
The process of an OFS is simple and not as complex as an IPO. An OFS can be managed only through the special window offered by the stock exchange. Investors can participate in an OFS from their trading account by placing a bid. Shares are directly offered by promoters and credited to the investor’s demat account on a T+1 basis. An OFS process can be completed in one trading session while FPO is opened up for three-four days, after which the allotment process starts. As per SEBI guidelines, only the top 200 companies can use OFS to raise funds.
5.2.7 What should I keep in mind before investing in an IPO?
There are a few things that we need to keep in mind before applying for an IPO:
1. Know the company: The best way to get this information is to go through the prospectus of the issue or through quality research reports. You should analyze the company’s financials, industry outlook, management experience and capabilities and objectives of the issue. Do check for any material litigations against the company or its promoters.
2. Valuation of the IPO: This is one of the most important aspects when deciding to apply for an IPO. You should compare the valuation of the company with listed peer group companies to understand if the band at which shares are being issued are justified. If the issuing company does not have any listed peers, then you should check the P/E ratio, earnings growth, Return on Equity (RoE), etc. that will help you in arriving at a decision. Keep an eye on the quality of earnings as it is more important than the quantity.
3. Listing gains: Do not invest in an IPO just for listing gains. It is a myth that all IPOs offer listing gains. There are many examples where IPOs have been listed on the exchange at a discount.
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