What is IPO? Detailed guide with definitions, types, and its 3 benefits you must know before applying for an IPO

You must have listened to the word IPO many times if you are an active investor or continuously watching the stock market. IPO means initial public Offer and as its name says it is the process of offering shares of any company by the promoters of any private corporation to the general public for the very first time. It is not like the company wants the public to be its shareholders but the company has its own requirements and to meet those, the company issues IPO for public issue. Here through the series of blogs, we will try to understand each and every detail of IPO and its advantages and disadvantages for us as an investor.

What is Initial Public Offering (IPO)

Any private organization needs money to meet its costs or for its expansions and the organization can arrange this fund in many ways. One way to raise money is from the general public by offering them to be the shareholders of the company. This process of inviting the public to invest in their organization and to raise funds for the company is called IPO (initial public offering). This means it is the procedure of selling its equity or shares to the public in the primary stock market.

An Initial Public Offer is just like a way for a company to raise investments from retail and small investors to meet the operational expenses of its projects and to get a wide reach in the market by associating with the Stock Exchange.

The primary stock market is the place where securities i.e. bonds and shares are sold by the company to the public for the first time. And through the IPO process, the company goes public for the very first time, so IPO comes under the purview of the primary share market. Similarly, a govt organization can raise debt capital from the market by issuing long and short-term bonds at a pre-decided coupon rate which depends on existing interest rates. So, the essence of the primary market is that here you can purchase the shares from the issuers of the security i.e from the companies.

A secondary share market is a place where the shares are traded at a fluctuating price depending on the demand and supply mechanism. Here, the shares are traded between the traders or investors only and the issuer of the share remains out of this market. Hence, the stock market is an example of a secondary market.

The price of the security/share also depends on many other factors but primarily on demand-supply. If you purchase an equity share in the stock market, it is supplied by another investor only who wants to sell those shares, and the company to which the share belongs doesn’t have any role in it. In the same way, bonds are traded here and you can trade them for profits.

Who issues IPO

IPO can be issued by both small and large firms depending on their capital requirements. Smaller and relatively new companies can use the funds raised through this process for expansion and to get reach by listing on the stock exchange, while large companies may use this method to become public-traded so that liquidity can be increased. There is another reason for issuing IPO is that amount raised through this process will directly go to the company, but once it gets listed in the market, shares will keep trading between the investors only.

Who can apply for IPO

  1. Resident Indian
  2. NRIs
  3. Non-Institutional Investors
  4. Qualified Institutional Buyers like Insurance firms, Mutual Fund houses, etc
  5. Minor below 18 can apply but it depends from IPO to IPO so one has to check the requirements and detail in RHP carefully

How do IPO works?

Now as the company decided to go public through IPO, there are some questions that we all must have in our minds:

1.         Why a company decides to go public means what are the benefits the company will have by IPO?

2.         Why did the not company take IPO steps in the early stages of its operations?

3.         What will be the benefits to the public if issued with IPO?

4.         What the existing shareholders of the company will do?

5.         What is the procedure of IPO and who is involved in this process?

And many more, so we will try to discuss each and every question in detail through this series of blogs. So, let’s start the journey to explore Stock Market.

why do companies issue IPO?

Why do companies issue IPOs?

Now, that’s a million-dollar question because on one side we are discussing that no owner wants small investors like you and me to be part of their organization while, on the other hand, companies are inviting people’s participation in their organization.

Now, one thing is clear, there must be some purpose of the company which can be fulfilled through this, or else why should anybody approach the public? So, we will discuss the reasons why companies issue IPO in the first instance and what in return the organizations will get. So, let’s discuss the key reasons for the issuance of it with its Pros and Cons for common investors like you and me.

IPO for Raising funds

As you, all are aware that only those companies that launch their IPO are well established and performing in the market for quite some time. A new company cannot launch its IPO in the market as there are some prerequisites that need to be met by the company before this issuance. Now, a well-established company needs funds for many reasons like its expansion, or to repay its debts taken in past from other investors. In general, companies have many sources to raise funds like angel investors, venture capitalists, and banks. But if a company needs more money it can go public to raise more amounts and in turn issue its share for sale.

Why IPOs and not banks?

Yes, you are right, the company can go to banks as banks are authorized by RBI to lend money. But companies avoid going to the bank when they have an IPO option in hand because the amount raised through a bank is debt and debt has to be repaid by the company in a time frame with interest. So, repaying the debts will affect the profit of the company while in Public Offering, money raised is not taken as debt.

Here the investors are issued shares of the company and there is no need to repay them back, hence it is not affecting the profit of the company in any way. The company has no prior commitment to repay the amount invested back to the shareholder of the company and profit and loss will be shared by each shareholder. 

IPOs to increase liquidity in the market:

Before the launch of the IPO, the company has limited shareholders with a heavy amount of investment and it is very tough for any shareholder to sell its shares for some minor requirements of capital. By issuing shares to the secondary market through it, the company and its investors will have enough liquidity.

An investor can now sell or purchase the share depending upon the capital requirements in small lots or in numbers. Liquidity means the assets which are very easy to be converted into cash. So by increasing shares in the stock market, the number of liquid assets is increased which will make the company fetch more investors and at the same time, small investors can invest in the company.

Opportunity for investors or employees

After launching shares to the public, the company provides an opportunity for early investors to exit their investments by selling their shareholding. In this way, the investors can redeem their investments through IPO routes and it will, in turn, increase cash capital for the company.

Name and fame by issuing IPO

By issuing IPO, the company goes to be public for the first time and hence many small and medium investors will come across the name of the company. In this way, the company will get name and fame and can make its brand status provided it emerged as profitable for the new small investors after the IPO launching.

Increase in the number of investors through IPO:

Since through IPO, company shares are offered to the public for the first time, it will surely attract many small investors to invest in the company. This process will lead to an increase in the number of investors for the company which in turn is profitable for the company to decrease monopoly and enhance liquidity.

Types of IPO

The company can offer its IPO in three main ways Fixed Price Process, Book Building Process, or the combination of both processes. There are some basic differences between these two processes which every investor must know before investing.

Sl No. Characteristics Fixed Priced Process Book Building Process
1 Pricing Investors know in advance about
the price of securities being
offered/allotted to him
The price of securities offered/allotted is not
known to investors and only an indicative
price range is known.
Share can be allotted within the range
2 Demand Demand for the shares among investors
is known only after closing the issue
The demand for securities by investors
can be checked every day as the book is being built
3 Payment Payment is made at the time of subscription
and refunds generated for unsuccessful investors
only after the allocation of shares
Payment is made to the company only
after the allocation of shares, till that time
amount remain blocked by the banks.
For unsuccessful investors, the amount will be unblocked
after the allocation of shares.

Types of Pricing in an IPO

Floor Price: Companies that are issuing IPO with the Book Building process usually decide on a price band for the issue and tell the same to investors in advance. This price band comes up with an upper level and a lower level, and the lowest price an investor is willing to pay is called a Floor Price. So, the Floor Price is the price that is the lowest level in the price band at which a bid can be made for that IPO. For example, if the price band of the IPO is 100-120 then 100 is the Floor Price.

Cut-off Price: This price is applicable for retail investors only and here retail investors have this additional option while bidding for IPO. Bidding at Cut Off-price means, the investor is willing to pay any price decided by the company after the book-building process.

The investor will pay the highest price when bidding at Cut Off-price, as investors are not aware of the listing price of the share. In this case, if the company decides the listing price at a lower level than asked Cut Off-price, the company will refund the additional amount back to the investor soon after the allocation of shares.

Advantages of an IPO

The primary objective of an IPO is to raise capital for a business and if a company is raising capital, it means it has some advantages, here are some of them listed below:

1. Best Investment Opportunity for Investors:

Best Investment Opportunity for Investors: Initial Public offers (IPOs) offers one of the best rewarding investment opportunities to investors. Good profits can be earned in the very short term (6 to 10 days) by investing in IPOs. Profits from the IPO investment can be maximized by applying for a large chunk in the High Net-worth Individual (HNI) category where the allotments are done on a proportionate basis in case of oversubscription.

If an IPO gets oversubscribed and allotted with the shares, it is likely that you will get a high incentive in terms of listing gain within a short span of 6 to 10 days.

2. Advantages for the firm:

Issuing an IPO is advantageous for the firm also as the company gets access to investment from the entire investing public to raise capital. This facilitates easier acquisition deals (share conversions) and increases the company’s exposure, prestige, and public image, which can help the company’s sales and profits.

3. Increased transparency:

Transparency comes with required quarterly reporting by the company and this will help a company in terms of increased reputation in the market. This will help a company receive more favorable credit borrowing terms than a private company.

Bottom Lines:

IPO is the process of offering shares of any company by the promoters of any private corporation to the general public for the very first time and it can be a tool of investment. But not every IPO generates good results for an investor and that is why applying to an IPO is generally seen as a bad technique of stock market investment. Although we can not outrightly reject the investment idea in IPO, you must do your research about the company before applying for its IPO.

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