In recent times, you would have heard the word Initial Public Offering (IPO) many times. Be it newspapers, analysts, news anchors, your friends, and my Twitter handle too 😛
Today we will see in detail what IPO actually is, how it works from start to finish and I will also answer some of the generally asked IPO queries.
An initial public offer of shares or IPO is the first sale of a corporation’s common shares to investors at large. The main purpose of an IPO is to raise equity capital for further growth of the business.
Eligibility criteria for raising capital from the public investors are defined by SEBI in its ICDR regulations and include minimum requirements for net tangible assets, profitability, and net-worth. SEBI’s regulations also impose timelines within which the securities must be issued and other requirements such as a mandatory listing of the shares on a national stock exchange and offering the shares in dematerialized form etc.
The IPO Life-cycle looks something like this (From company deciding to go for an IPO to the company getting listed on exchanges):
Following are the steps in an IPO Process –
- Preparation of Registration Statement
- Getting the Draft Red Herring Prospectus (DRHP) Prepared
- The Roadshow (Marketing the IPO)
- Get approval from SEBI and Stock Exchanges
- Deciding On Issue Size and Issue Price
- IPO Opens for Public for bidding
- Issue Price Determination & Share Allotment
- Listing & Unblocking of funds
Let’s delve deeper into each step and what it entails –
Preparation of Registration Statement
To begin an IPO process, the company involved must submit a registration statement to the SEBI, which includes a detailed report of its financial health and business plans. SEBI scrutinizes this report and does its own background check of the company. It must also see that the registration statement fulfills all the mandatory requirements and satisfies all rules and regulations.
IPO Process Initialization | Getting the Draft Red Herring Prospectus (DRHP) Prepared –
A book runner is appointed as a lead manager (The book runner is the lead underwriter in a company’s initial public offering).
Registrar to the issue is also appointed (IPO Registrars are independent financial institutions registered with stock exchanges and appointed by the company going public mainly to keep a record of the issue and ownership of company shares.).
Syndicate members are commercial or investment banks, usually registered with the market regulators, SEBI in India, or registered as brokers with stock exchanges, responsible for underwriting IPOs.
They work as intermediaries between the Issuer Company and investors who bid for IPO stocks.
Note – A lead underwriter is usually an investment bank that helps an organization to sell its shares to the public for the first time. In the case of large offerings, a group of underwriters comes together to form a syndicate and the entity leading this syndicate is the lead underwriter.
In the case of smaller offerings, only one investment bank is involved and this person is the lead underwriter of this offering.
An extensive document that covers all the information of the company (think A to Z about the company – Financials, promoter information, business model, industry data, financial ratios, Risks, objects of money raised, etc) is created. This is called the IPO Draft offer prospectus or ‘Draft Offer Document’.
The draft prospectus is filed with the capital markets regulator SEBI (Securities Exchange Board of India).
The Roadshow (Marketing the IPO)
Once filed, Roadshows (A roadshow is a series of presentations made in various locations leading up to an IPO. The roadshow is a sales pitch or promotion made by the underwriting firm and a company’s management team to potential investors before going public.) for the IPO are done.
Get approval from SEBI and Stock Exchanges
After reviewing the Draft Offer Document, SEBI will either ask lead managers to make changes to it or to go ahead with IPO processing.
Once the ‘Draft Offer document’ cleared by SEBI, it becomes an “Offer Document”. Offer Document is the modified version of the ‘Draft Offer document’ with SEBI suggestions.
“Offer Document” is submitted to the registrar of the issue and stock exchanges where Issuer Company is willing to list.
Once the “Offer Document” gets clearance from Stock Exchanges, the issue date & issue price is decided with the help of the Issuer Company. Modifications are done in the Offer Document and now it is called Red Herring Prospectus and is made available to the public.
Deciding On Issue Size and Issue Price
After the SEBI approval, the company, with assistance from the underwriters decides on the price band of the shares and also decides the number of shares to be sold.
There are two types of issues: Fixed Price IPO and Book Building IPO
Fixed Price IPO – In a Fixed price issue – the company decides the price of the share issue and the number of shares being sold. Ex: ABC Ltd is going to do a public issue of 10 lakh shares of face value Rs 10/- each at a premium of Rs 55 translating into a price of Rs 65 per share.
Book Building – Now this price band is arrived by a process of book building. The investment bankers investigate the company financials, its peers, its management, and also they decide on a price band.
For example, if XYZ is in the textiles sector, they look at their business earnings and listed peers and they decide a price band of 490–630.
After investment bankers decided the price band of Rs 490–630, they take this company’s data and price band to market makers such as Mutual Funds, PE investors, etc, and build a book of demand and price.
Suppose they got maximum demand in the price range of 530–590. Now the company comes out in the market with its IPO with the bid range price of 550–570 rupees.
IPO Opens for Public for bidding
The IPO is announced. The management does a Broker/HNI/Press Meet and also does an analyst meeting a few days before the issue opens for bidding.
Issue Price Determination & Share Allotment
Once the subscription period is over, members of the underwriting banks, share issuing companies, etc. will meet and determine the price at which shares are to be allotted to the prospective investors.
The price would be directly determined by the demand and the bid price quoted by investors. Once the price is finalized, shares are allotted to investors based on the bid amounts and the shares available.
The demand and supply are taken into account and the price at which maximum demand has come will be the cut-off price. So in this case suppose maximum allocable demand has come at 585 rupees and hence this is the price at which the share will be allocated to the investors. After it lists the market forces of demand and supply will take the share price up or down.
After it lists the market forces of demand and supply will take the share price up or down. If there is more supply than there is demand, share prices will fall, and if it is vice versa share prices will rise.
Note: In case of oversubscribed issues, shares are not allotted to all applicants.
Unblocking of funds & Listing
Investors who have applied through ASBA & to whom shares were allotted would get the shares credited to their DEMAT accounts & their funds getting debited from their bank account or else for those investors to whom the shares were not allotted, funds would get unblocked in their bank account.
The last step is the listing in the Stock Exchanges.
That is how the complete IPO Lifecycle looks like. Now let’s look at some of the frequent doubts and questions that people have on IPOs – we will solve them in the simplest manner possible!
IPO Timeline (From IPO open to listing)
It takes 5 business days from the IPO close to the IPO listing date. Note that SEBI is in talks/discussions to reduce this listing timeline to 3 days. Making UPI a payment option is a step towards the same.
Frequently asked Questions and their answers:
Why do prices of IPO companies skyrocket after their listing?
I believe stock prices skyrocket for IPOs mainly because of two reasons:
Demand Supply Law/FOMO/ Madness – What happens in IPOs is that the supply stays the same but the demand is huge for the same amount of shares (thanks to marketing tactics and narratives) and hence people start putting more and more premium on the shares to buy them.
Hence when the IPO lists on the stock exchange it does so with a huge premium. This is famously referred to as the IPO ‘Pop’. Seeing the premium, more people get greedy and the circle becomes complete.
The market is overvalued – Suppose there is a bull run going on in a country’s stock markets. Hence when a new company issues its IPO and when it lists there is a frenzy to buy the company’s shares.
Again this happens only because it is quite possible that the company’s IPO itself may be overpriced.
This usually happens because IPO issuing companies know there is heavy demand for shares during a bull run and they come only to milk the markets.
What is an IPO Prospectus?
IPO Prospectus is also called an offer document or DRHP (Draft red herring prospectus).
Capital Markets or ideally Primary markets help a company raise capital (for a stake in their company) or borrow money (in exchange for interest payments and principal repayment) from investors for the first time.
An offer document, as the name suggests is a document prepared by the company for the various classes of investors when they are raising capital from the Primary Markets.
An offer document contains a vast amount of information. An offer document contains things such as:
- Risk Factors in the Issue
- Investment bankers to the Issue
- Registrars to the Issue
- Issue Open and Close Date
- Pricing of Issue
- Opportunities in investing in the Issue.
- Company Strengths
- Company Strategies
- Objectives of the Raised Capital.
- Information of Company Management (Remuneration and DIN)
- Equity Capital and Share Issuance History of Company.
- Balance sheet for the last 3 -5 Years.
- Profit and Loss Statement for the last 3-5 years.
- Cash Flow Statement for the last 3-5 Years.
- Company Financial Ratios such as Return on Net Worth, Price to Earnings , Price to Book Value.
- Peer Comparison.
The Significance of the Offer Document is that it helps an investor to get the complete picture of a company going for capital raising. This is important because:
- It helps investors to make an informed decision of investing or not in the Issue.
- It helps investors to save time as the investor does not have to consume a lot of time researching the quantitative and qualitative factors of the company.
- An Offer Document is first reviewed and audited by independent auditors appointed by the company and then the offer document is submitted to the Market Regulator: Securities and Exchange Board of India. Only after SEBI vets it, the company is allowed to raise capital in the Market.
What is the sure-shot way to get an allotment for an IPO?
There is no sure way to get allotment for the applied IPO. In case of over-subscription, the registrar to the particular issue does a lottery draw and allots the securities.
What exactly is the difference between an SME IPO and a regular IPO? Is there any risk in applying to SME IPOs?
The minimum investment: The minimum investment in a Normal IPO is Rs 12,000 to 15,000. On the other hand for SME IPO it is Rs 1,20,000 to 1,50,000. This is because only long-term and capital-intensive players are allowed for SME IPOs. The main reason for this rule is that SMEs are upcoming businesses and volatile and impatient investors may hammer a listed SMEs market cap.
Business Roles: Normal IPO companies may have clearly defined business roles such as CFO, CTO, CEO, CXO whereas it is would not be surprising to see 2 major roles be handled by the same person in a SME.(as the company size is small)
Underwriting: Full underwriting is compulsory in SME IPO whereas underwriting in a normal IPO depends on the issuing company.
Allottees: Allottees should be more than 200 in SME IPO whereas in normal IPO certain percentages are set. ( For Retail Investors, Non-institutional Investors, and Qualified Institutional Buyers) and no certain allottee number is pre-defined.
If an IPO is undersubscribed, does anyone lose money? How does this work?
If an IPO is under-subscribed no one loses money because the IPO going company has to refund the amount to the investors who had applied.
Example: Green Signal Bio Pharma
The timeline for IPOs is typically three days. Green Signal had extended its IPO timeline twice — from November 11 to November 17, and then from November 17 to November 22, 2016. (Even Parag milk foods had extended its IPO deadline, however, the IPO got through)
Besides extending the timeline for the second time, the company also lowered its pricing on November 17 from Rs 76-80 a share to Rs 68-76 a share and was hoping to raise Rs 110 crore at the upper end of the price band.
Minimum Subscription – The minimum shares the company needs to get from the public out of the total issue by the date of closure. (Presently every company needs to raise 90% of the issued amount). Else, the company shall refund the whole amount received. This 90% has to be exclusive of the cheques that are not cleared or the ASBA application amount in the current scenario.
It’s the Company’s Loss – It may look like that the investors didn’t lose money and the company didn’t get the money.
No harm was done, right? However, the IPO company gets big negative publicity in the markets because it shows that the investors are not interested at all in buying the shares of the company which eventually lowers its reputation, even if it is a good company.
(Also they may lose some money in investment banking expenses, investor roadshows, prospectus filing charges with SEBI, and more if any.) They may not lose anything tangible but they may lose out on intangible things such as Customer loyalty, goodwill.
During IPO bidding, where is the blocked amount of investors stored until shares have been allocated to them?
The amount is stored in the investor’s account itself. ASBA stands for Application Supported by blocked amount; the amount merely gets blocked till the time of allotment. If you get an allotment, money will be deducted and if you don’t get allotment money will be unblocked.
For instance, if you apply IPO shares worth 15,000 from your bank account which has 15,100 rupees when you check your balance it will just show a net of 100 rupees (total balance will show as Rs 15100). If you don’t get the allotment, the balance will be 15,100 again.
Who are the Participants in an IPO?
Should Retail Investors apply in IPOs?
Before Investing in IPOs, you should understand the business of the company, its past financial performance, the purpose of raising capital, quality of management, risks, valuation, peers, industry setup, etc. If the IPO checks out on all the parameters set by a retail investor, they can invest in an IPO.
What are the things to look for in an IPO before investing? (This is a entire topic in itself, below points are just some important ones)
- The price band for IPO is not overpriced (an overpriced issue automatically shows that the exiting investor or management is greedy for money and would not even leave money on the table for investors). D mart IPO was priced such that ample money was left on the table for investors. This speaks highly of Mr. Radhakishan Damani.
- It should not be an offer for sale. Offer for sale means that the company would not get any money raised from IPO, but instead, the exiting investor will get all the money. ( On the contrary, some recent Public sector companies’ OFS sailed through nicely.) So this is case-specific.
- It is highly important that you check how the proceeds raised from the IPO will be used. (debt repayment, new CAPEX, new factory, general corporate purposes, etc)
- Financial Metrics: Debt to equity, RoE, RoA, RoCE, Promoter Holding, Cash flow analysis, and so on. (Be sure to run some forensic checks on the accounting numbers and also check related party transactions)
- Qualitative Metrics – Ask tough questions to the management on the Analyst webinar before the IPO (they will mostly not answer it), see capital allocation, see management remuneration, see the breadth of the management (experience, age, etc), see the capital structure (to see if they haven’t done any allotment to themselves or others at very lower prices compared to IPO. Recent examples had many such instances where IPO price was 2x the recent share sale to promoter or promoter groups or institutions which is a big red flag)
- The Sector should be a growing sector so that company can perform better in the future.
- Do peer analysis to check if the company is overpriced or not. Peer Analysis also helps you to know how much the company has captured the market with respect to its peers.
- Many People buy IPOs solely for the ‘IPO pop’ (IPO pop means monetizing on the premium listing of the stock on exchange). This also influences the stock to move wildly in the starting couple of days. The stock may rise rapidly or fall rapidly but if you have a strong conviction and you have strong research/facts to back it up with, one may hold on to the stock because the price will reflect its true value only in the long term.
Is it profitable to invest in IPOs for the long term?
It can be depending on the companies that one chooses and the runway ahead. Some of the wins in IPO have been Wipro (Rs 10000 in 1980 IPO of Wipro will be more than 600 Cr excluding dividends today!), Dmart, etc. What matters is the business, promoter, and the runway ahead for the business to grow.
What happens 99.9% of the time in IPOs is that the price is so expensive that there is no room left for upside. But there are promoters/groups that leave ample gains on the table for investors.
Some examples where IPO was under-subscribed but the rest is history for these IPOs –
What exactly is the Grey Market Premium (GMP) and why I say it’s just a vanity metric? Why shouldn’t GMP be taken seriously?
Grey Market Premium or GMP as it is called denotes the premium or discount at which an IPO going company trades at and it indicates a probable listing price.
This is the textbook definition of it – the real definition? It stands for Garbage and meaningless premium (GMP) and is just a metric that is created out of thin air by a few traders and speculators to make an issue look enticing.
In recent times, we have seen a huge difference in grey market premiums and actual listing prices.
Very short-term players who just play for listing gains try to use it as a major data point for their study but as we will see the grey market is just an indicative listing price and should never be considered as a reliable data point.
Now Grey Market premium is a concerted effort of market operators to make an issue look enticing. When you show to the market at large the premium over an IPO, they are bound to be attracted by it.
Now I say it is a vanity metric because first of all, it is, secondly more often than not it is misleading or incorrect. Let me give you a few examples –
Never buy IPOs on the basis of Grey Market Premium (GMP)!
- SBI Cards had a very good GMP of Rs 300 (issue price was 750 -755) but due to COVID, GMP vanished and stock listed at a discount of Rs 661!
- Angel broking issue price 306 – grey market range – 4-7₹ premium
Listed – 275₹, went to Rs 380 aided by great results in the Q2 quarter and now at Rs 292
- Mazagon Dock issue price 145- the grey market was 100+, listed – 216, now at Rs 211
- Mahindra Logistics GMP was quite good a day before the listing day. On the listing day, the GMP went to 0 in a few minutes as it was the Gujarat election outcome. BJP was losing seats but then counting took a U-turn, and BJP was shown in lead and hence the stock listing also recovered to list at par!
- Gland Pharma GMP was just Rs 10 on an issue price of Rs 1500, but the stock listed with a good premium and gained thereafter too. Currently trades at Rs 2465
- We saw the same in Ease my Trip IPO (high divergence between GMP and listing)
- In IPO’s like SBI card, Angel broking, Mazagon Dock, UTI AMC, Gland Pharma grey market actually did not match the actual listing.
Leave GMP – always check fundamentals first!
What are IPO Narratives? Why do i talk about it a lot?