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This article is written by Simran Jeet pursuing Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho.

Introduction

IPO stands for Initial Public Offering. It is a process under which a privately held company becomes a publicly-traded company by offering its shares to the public for the first time.  A private company, which has a limited number of shareholders, distributes the ownership by going public by trading its shares and that’s how a company gets listed on the stock exchange.

If a company decides to become a public limited company hires an investment bank to handle the IPO. Both the company and the bank discuss and work out all the financial details of the company in an agreement and that agreement is known as an Underwriting Agreement. After entering into the agreement, they file the registration with the Securities and Exchange Commission (SEC). SEC cross checks all the given data and the details and if everything falls into place, then it allows the company to announce a date to offer IPO. 

This article will provide you an insight into the structure of an IPO and how companies are using it as a method to expand their business and the required background check of the company will bring huge returns to the investors.

Investment in IPO

To decide whether to put your money in an IPO is a tricky question. It becomes even more difficult when you are planning to invest in a new company. So, in that situation, it is very important to do a background check of the company and you need to scrutinize all the available information. It is also very important to find out about the Fund management team and how they are planning to use funds that they have generated through IPOs.

So, in short, a historical check of the company is required because if you invest in an IPO you are exposed to the profit and loss of the company. It is very important to find out that the company you are investing in is not indebted to its public investors and reimbursing its capital to its public investors.

Types of IPO

The different types of IPO that a company can offer are specified below:

  • Fixed Price Offering

Fixed Price Offering is a very simple and straight form of IPO. The company announces the prices of the initial public offering in advance and if you participate in it, you are ready to pay the full money.

For example; any medical instrument manufacturing company decides to expand its manufacturing plants by raising capital. They decide to raise this capital by selling the shares of the Company which is an IPO route. 

  • Book Building Offering

In Book Building Offering, the stock price offered is at a 20% cap. So, the lower level of price is the floor price and the upper level of price is known as cap price. Initially investors bid for the price that they are willing to pay for the shares. This practice gives the company an idea about the interest of the public and after the said process company declares its final price.

For example, a kids’ clothing company decides to raise capital for business expansion. Therefore, they decide to take their company public and hire a merchant banker who analyzes the company’s future prospects and net worth. The merchant banker wants to evaluate what range of shares would be suitable for the company. It’s a process to analyze how much investors would be willing to pay for the shares. The company issues 10000 shares and the price range is decided to be in Rs.100-110. For 3000 shares, the bids were received at Rs.100, for 4000 shares it was Rs. 105, and for 6000 shares it was Rs.110. The final cut-off price will be Rs.105 because bids for 6000 and 4000 shares were at Rs.110 and Rs.105. So, the company will refund the 100 Rs. bid price and also the balance amount to those who bid at Rs.110. Because the final cut-off price will be at Rs. 105. 

Benefits of IPO

  • Get in on the action early

Investing in an IPO will turn out to be beneficial if a company will grow rapidly in the coming future and that’s how you will be able to grow your wealth in the long run. If you are investing in a company that is making good profits in the market, then you will also grow along with the growth of that company.  

  • Long term goals

Investing in an IPO is like an equity investment. IPOs have the potential to bring you a lot of profits in the long run and by that, you will be able to fulfil your long-term goals like buying a house. Indian IPO market is also growing and it has generated 11 billion through IPOs in 2017.

  • Transparency

You will get to have clear transparency of the price just like big investors. You will be able to see the price of the securities in the IPO order. So, the entire procedure is very transparent. After the company is turned into an IPO then the share prices will highly depend upon the changing market conditions.

  • Buy cheap earn big

When companies are planning to go for an IPO, then their shares are offered at discounted prices. So, when a promising company will float for IPO, it is going to offer its shares at the cheapest price possible but after it makes a profit in the long run, investing in that company will be next to impossible for any.

Let’s take the example of Amazon. When Amazon.com floated an IPO in 1997 each share was priced at $18 and the people who bought the shares at that time have earned millions of profits through the IPO.

Why does a company offer an IPO?

  1. IPO is a money-making process. When a company offers an IPO, they are looking for money and they need that money for the growth and expansion of their business, to repay loans, etc. 
  2. A company going public means that the company has gained enough success that now they are ready to be listed on the stock exchange. It’s a matter of pride for any company.
  3. The market is getting bigger and more demanding. So, a public company can offer more stocks and it gives a better way to acquisitions and mergers as the stocks can be issued as a part of the deal.

Underwriting agreement

It is an agreement that has been entered between the syndicate of investors and the company that is issuing their shares for the investment. The purpose of this agreement is to ensure that everyone has understood their responsibilities and everyone agrees upon the price which has been offered, the resale price, and the settlement conditions of the agreement.

There are different kinds of underwriting agreements are:

  • The firm commitment agreement

This is the most desirable form of the underwriting agreement. Because under this agreement the purchaser purchases all the issued shares regardless of the fact if they can sell it further or not. Under this agreement, all the money of the issuer is guaranteed right away. 

  • The best-efforts underwriting agreement

This type of agreement is used for the sale of high-risk securities. An underwriter will do its best to sell the securities but he is not obligated to purchase all the shares.

  • The mini-max agreement

This is considered to be the best type of underwriting agreement and it does not become effective until a minimum amount of securities is sold. Once the minimum is sold, an underwriter can sell up to the maximum. 

Steps to investing in an IPO

Investing in the IPO process is further divided into 7 steps, but before following all the required steps, it is very important for all of us to identify the opportunity of investing in that IPO, and then we are required to follow the required procedure. This process is complicated and long drawn and further divided into 7 parts.

Step 1: Hiring of an underwriter 

To begin with the process of the initial public offering, a company will have to hire experts and they are underwriters or investment bankers. They will closely study the market deal and will analyse the amount that can be generated through IPO’s and the securities issued against it. They will act as intermediaries between the company and the investors and they will make the company sign an underwriting agreement and the underwriting agreement contains the following details:

  • Details of the deal.
  • Amount to be generated.
  • Securities being issued.

Step 2: Registration for an IPO

The second step of IPO involves the preparation of registration statements along with the preparation of the prospectus, which is also known as the Red Herring Prospectus (RHP). Submission of RHP is mandatory as per the Companies Act, 1956.

Key components of RHP:-

  • Definitions
  • Risks
  • Use of proceeds
  • Industry description
  • Business description
  • Management
  • Financial description
  • Legal and other descriptions

This document has to be submitted three days before to the registrar of the company before the IPO opens up for public bidding.

Step 3: Verification of disclosure of the company

Then the Security Exchange Board of India (SEBI) verifies the disclosure of the company. If the application is approved, the company can announce the date for IPO.

Step 4: Making an application

The company will make an application to the Stock Exchange for showing its initial issues.

Step 5: Create a buzz

Before the IPO opens to public bidding, the company tends to create a buzz in the market through advertisements and promotion. Two weeks before the bidding is open, the company and its staff tend to highlight the achievement of the company through hoardings and online advertisements in order to attract potential investors.

Step 6: Pricing

The company can now begin the process of pricing the IPO. The company can price the IPO through fixed price IPO or by Book Offering. Under fixed price, the company will have to announce the price of its shares in advance, and under book offering the company will decide the price range of 20% and the bidder will have to quote their price under the given price range. 

Step 7: Allotment of shares

After the bidding is done, the company will begin the process of allotment of shares as per the number allotted to each investor. In case of oversubscription, partial allotments will be made. The IPO stocks will be issued to the company within 10 days of the last bidding.

Risks involved in investing in an IPO

  1. The biggest risk of investing in an IPO, that there is no guarantee of receiving the shares. If the shares are subscription based then any number of individuals can apply for them. Then, the company will allot the shares on a proportional basis and if you are a small-time investor and the individuals are many then the Pre-IPO share mechanism of India will hardly get you any shares.
  2. When you buy Pre-IPO shares then you run the risk of receiving less than what you invested. The price of Pre-IPO shares is only decided only after it is listed and there are many cases where the listed price is turned out to be less than the purchase price.
  3. External influence can affect the price especially when companies are running their business as per the government legislation which can change as per the present political situation of the country.

Conclusion

It has been concluded that an IPO can be a bit tricky and the process is very long and complicated. But, if the company that you are invested in is earning huge profits, then you will also grow along with the company. But, before getting into the market, a little study and a  background check of the company is required.

References


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