Initial Public Offering (IPO): Meaning, Types, Advantages & Disadvantages

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Initial Public Offerings, or IPOs, are a special way to issue shares and turn a private firm into a public one. A great chance for the general public to participate and profit from their investment is provided by the company's issue of shares to the public.

A private corporation initially develops alongside its early financiers, founders, and stakeholders. A firm decides to launch an Initial Public Offering once it has reached a specified milestone and the management has determined that it is stable enough to manage SEC (Securities and Exchange Commission) laws, grow, and diversify utilising investor funds. Through this, the general public is given the opportunity to purchase shares in the corporation.

How are IPO shares allocated to each of the investors' categories?

There is a different formula for allocating shares to each of these categories. For example, in the case of retail investors (up to Rs2 lakhs per IPO), the gross demand will be evaluated based on the number of applications received. The issue is said to be oversubscribed when the demand exceeds the allocation. The retail category is allotted shares based on a lottery in such cases. This is a computerised process that ensures fair allocation of shares to investors. However, the guiding principle in this category is that every individual who has applied for the minimum lot can get some shares. This ensures a better spread of equity ownership.

In the case of QIB, the allocation is done on a discretionary basis, while for NIIs, it is done on a proportionate basis. However, as per the recent notification by SEBI, even the NII category allocation will be done on a lottery basis, like the retail quota.

 

How Initial Public Offering Works?

An IPO is often launched by a corporation to enhance equity capital, generate funds for the future, permit simple asset trading, or monetize current shareholder interests. 

The prospectus contains information regarding the initial sale of shares that may be evaluated by both institutional investors and the general public. Comprehensive information about the prospective offers is provided in the lengthy prospectus. 

Following the IPO announcement, the listed stock is available for trading. The minimum free float requirement for shares is established by the stock exchange both in absolute terms and as a percentage of the entire share capital. 

Types of IPOs

There are two types of IPOs. They rely on the kind of price generation that the business or underwriter is aiming for. These come in two varieties:

In a fixed-price offering, the firm sets the initial stock price, and any investor or buyer must pay that price per share in order to purchase the required quantity of units.

In a book-building initial public offering (IPO), the firm sets the price range for the upcoming IPO, where the floor price is the lowest and the cap price is the highest. With polls on what would be the value of the share, the underwriter and the company's investors decide on the price. The stocks are awarded to the chosen bidders once the bids are placed.

IPO Advantages and Disadvantages

Advantages of IPO

Capital Raising: A corporation can generate more money for its operations through an Initial Public Offering (IPO). A business can swiftly obtain a sizable quantity of money by offering shares of their firm to the general public.

Gain in Business Credibility: When a firm goes public, it must abide by a number of laws, including the Sarbanes-Oxley Act. It contributes to boosting the company's credibility with investors and attracting new funding.

Access to Debt funding: Publicly traded businesses have more access to debt funding than private businesses. Companies who need to fund significant projects or acquisitions may find it useful.

Brand Image Improvement: Going public may assist a company's brand image and exposure in the marketplace.

Capital raising: An IPO is a successful method for a firm to raise money. This cash can be used to support debt repayment, business expansion, new initiatives, and acquisitions.

Increased visibility: A company's visibility and reputation rise when it becomes public. It may draw more partners, suppliers, and clients.

Disadvantages of IPOs

Costly procedure: Making a public offering is a costly procedure. In order to be ready for the IPO, businesses must pay expensive fees to accountants, investment banks, and attorneys.

Increased Regulatory Compliance: Prior to going public, businesses must abide by a number of requirements. For businesses, it may be highly expensive and time-consuming.

Loss of Control: After a firm becomes public, its founders and management could no longer have complete control over it. Some business owners may find it challenging to accept.

Increased Risk: A company's risk may increase if it goes public. Due to the rigorous investigation of the company's financials, investors may suffer volatility in the company's shares.

Privacy loss: When a business goes public, it is required to reveal its financials and other information, which may result in a loss of privacy.

Terms Associated with IPO

Issuer: The business that offers the stocks in an IPO does so to raise money.

Underwriter: An underwriter is a banker, financial institution, or broker who assists the firm in underwriting the initial public offering (IPO). These serve as a middleman between the general public and the issuer. 

Price Band: In essence, a price band is the lower and higher share prices at which a firm would go public. 

Issue Size: In an IPO, the term "issue size" refers to the quantity of shares issued multiplied by the value of each share.

 Under subscription: When fewer shares are sought for by the public than the firm has issued, this situation is known as being under subscription.

 Oversubscription: This occurs when a firm receives more applications than there are available shares for the public to purchase.

DRHP: The offer document, or drafted red herring prospectus, is what this term refers to. In the event of a book-built issuance, it is a preliminary registration document created by investment bankers for the IPO issuing firm. The document includes the company's financial and operational data as well as a few additional details, such the reason for the fundraising effort. 

RHP: A book constructed issue's preliminary registration document submitted to SEBI is known as a Red Herring Prospectus. It is missing information on the quantity of shares and share price that are being offered in a particular issuance. 

Types of Investors in IPO

Three broad categories in the IPO investments. These are as follows:

Large investment companies, mutual funds, a scheduled commercial bank, as well as a few other organisations that have been registered with SEBI are examples of qualified institutional buyers (QIBs). In a book-built issuance, no more than 50% of the securities must be set aside for this category, while a compulsory book-built issue must reserve at least 75% of the securities. 

Retail Individual Investors (RII) are individual investors who submit applications or bids for shares with a total value of no more than 2 lakh rupees. In the event of a book-built issue, at least 35% of the shares must be assigned to this group, and no more than 10% may be in the case of a forced book-built issue. In the event of a fixed price issuance, at least 50% of the shares are assigned.  

Investors who are neither QIBs or retail clients are considered non-institutional. High Net Worth Individuals (HNIs) or business entities are examples of this. In the event of a book-built issue, at least 15% of the stocks are set aside for this group of investors, and no more than 15% in the event of a mandatory book-built issue. 

How does a company benefit from an IPO?

IPOs offer several advantages, some obvious and some not so obvious. One of the obvious reasons for an IPO is that it allows companies to raise fresh money and give an exit to early shareholders. The capital can be used to fund expansion, diversification etc. In addition, a listed company has greater acceptance since it must be more transparent and ensure more necessary disclosures. Above all, the IPO enables the listing of the stock. Listing aids wealth creation for shareholders, provides a basis for the valuation of the company and becomes a currency for future inorganic growth.

IPO Process

The IPO process consists of essentially two parts. The first phase of the offering is the pre-marketing phase, and the second is the actual initial public offering. A company that wants to go public will either make a public statement to attract interest or ask underwriters for confidential bids.

The underwriters, who manage the IPO process, are chosen by the business. A company may choose one or more underwriters to co-manage specific stages of the IPO procedure. The underwriters manage each stage of the IPO process, including due diligence, document preparation, filing, marketing, and issuance.

Conclusion

The occasion of an IPO is keenly followed. It can turn out to be a losing investment or a big potential for profit. Investors trying to take advantage of the discounts may be drawn to IPOs since they are notorious for having erratic opening-day returns. An IPO's price often stabilises over time into a consistent value. You may wager on the newest IPO to hit the markets by opening a free Demat account.
 

Frequently Asked Questions

Despite the fact that the terms stock and share are sometimes used interchangeably, an IPO refers to the sale of stock by a firm. 

An IPO investment may be a wise choice. You could gain later when the price rises over time if you buy a stock with significant upside potential at the beginning.

A private firm goes public through an initial public offering (IPO), which involves selling its stock on a stock market. In order to sell their stock on the open market, private firms work with investment banks, which requires intensive due diligence, marketing, and regulatory compliance.

Companies go public via an IPO to generate cash for a range of reasons, including supporting expansion, paying off debt, making acquisitions, and providing liquidity for current shareholders. 

The majority of the time, anybody with a brokerage account is eligible to invest in an IPO, however there may be limits or limitations depending on the investor’s location, net worth, and financial expertise.