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For business expansion or for other reasons a company can raise capital in two different ways. One way is to get equity funding and the other is to get debt funding.
If a company wants debt funding, it could go to a bank or any other financial institution and borrow money from them via taking a loan but if the company isn’t in the favour of borrowing money and paying interest then it can raise equity funds by giving a specific percentage of the company’s equity to the investors by issuing shares.
IPO is a way that a company uses to raise equity funds. But it doesn’t mean that IPO is the first time when the company is raising equity funds in its life.
There are so many funding stages that a company goes through before coming up with an IPO:
What is an IPO in the Stock market?
An IPO is a type of public issue in which a public limited company issues its fresh and new shares to the public investors for the first time and that’s why it is named “Initial Public Offering”.
IPO is the first time, an unlisted company issues its shares to investors.
Types of IPO
As through IPO, a company issues its shares but one cannot decide how much capital the company is gonna raise if the company does not reveal how much money it wants per share i.e. issue price. and the number of shares it is going to issue.
Issue Price is the price at which the company issue its shares in IPO. In a Fixed price issue it is known to the investors as the company fix this price before issuing its shares. But, In the Book building issue it isn't known to the investors as the company decides it after the issue closes and from the range of price band and the deciding price is known as cut-off price.
So, there are 2 types of IPO and in each type, we use a different method to decide the issue price.
1. Fixed price Issue
- The company decides a price and the investors need to buy shares at this price as it is the issue price. e.g. 100 rupees.
- It remains open for 3-10 working days.
- Demand for the shares is known only after the issue closes.
2. Book building Issue
- The company decides a price band in which investors bid. e.g. 100-120 rupees.
- It remains open for 3-7 working days.
- Demand is known every day during the offer period.
Issuers prefer book building issue over fixed price issue as the book built issue gives them the opportunity to discover the price and demand. This way, the issuer is able to ensure that the issue generates as much value as the market is willing to provide. (So, in this article we'll discuss the whole topic of IPO in context of Book building Issue.)
Why IPO?
There are so many reasons, why a company raises capital by going public:
- Money for day-to-day business operations.
- To expand its business i.e. for growth and expansion.
- To pay off debts.
- An IPO can be seen as an exit strategy for the company’s early investors via an Offer for sale cum Public issue (IPO cum OFS/ OFS cum IPO).
Types of Investors in an IPO
Investors are divided into 3 categories based on the amount they invest in the public issue:
- RII (Retail Individual Investors)
- HNI (High Networth Individuals) or NII (Non-institutional Investors)
- QIB (Qualified Institutional Bidders)
Well, the main categories are only RII, HNI and QIB but there is also another category of the Company’s Employees for whom the company reserved 1-2% of the shares as a way of awarding them for the risk they took in associating with a new company.
The Employee category can’t invest more than 5 lakh rupees in the IPO of their company.
Entities involved in the IPO process
There are so many entities involved in the procedure of an IPO. At first, the Issuer (the company that is issuing IPO) needs to submit all the required documents to the market regulator which is SEBI and to the stock exchanges where the company is willing to get listed and also to the RoC (Registrar of Companies). The Investment bank, underwriter, bankers to the issue and RTA are the SEBI registered intermediaries (between the company and the investors) which help the company conduct the IPO.
1. Investment Bank
Investment banks are the most crucial intermediaries of all. The company appoint them first. An Investment Bank or I-Bank is also known as Merchant Bank.
A Merchant bank is responsible for many things:
- Prepare the initial and final prospectus of the company.
- Calculate the company’s valuation and help the company to decide the issue price (in case of fixed price issue) and come up with a price band after discussing with Institutional investors (in case of book building issue).
- Ensure compliance with the legal formalities i.e. whatever the documents are required by the SEBI and stock exchange.
In an IPO there could be many I-banks and the one that works as the leading investment bank is known as the Lead Manager/ Lead Arranger/ Lead Coordinator and Bookrunner.
In the case of Book built public issue, a merchant bank is known as Book running lead manager (BRLM).
2. Underwriters
A bank, financial institution, a merchant bank and a broker can be an underwriter in the IPO process. But in most cases, the issuer appoints a merchant bank also as the underwriter.
The underwriter’s job in the IPO process is to subscribe to the unsubscribed shares of the company. Therefore, underwriters come into play when there is a situation of under subscription of shares(subscription less than 90% of the issued shares).
3. Bankers to the Issue
The Bankers to the issue accept all the applications on behalf of the Issuer Company. These applications are then submitted to the RTA to further process.
It manages the Escrow account of the company.
RTA is responsible for transferring the shares from the company’s account to the investor’s Demat account and is also responsible to refund the application money to the investors who bade less than and more than the cut-off price or issue price.
5. Depositories
Depositories hold shares in Demat form of the shareholders. If the investors during the IPO got the shares their shares are transferred to their Demat account which is maintained by the depositories.
6. Brokerage firms
The Stock Brokers and Sub Brokers receive a commission from the Issuer for inviting the public to subscribe to the shares offered by it.
IPO Process
In a book-building issue, the demand for the shares is known to the company on the daily basis during the offer/bidding period. The book-built issue allows the issuer to discover the price and this price is decided by the demand of the shares among the investors.
If the demand for the shares is high then it means that the IPO will get oversubscribed, if demand is low in the market then it will get undersubscribed and if the demand is similar to the supply then the IPO will get fully subscribed.
Conclusion
An IPO is a way through which a company raises equity funds from the general public and other types of investors by issuing fresh and new shares. There are 2 types of IPOs, one is known as a fixed price issue where the company decides the issue price before the opening of IPO and the other is book building issue where the investors bid in a price band decided by the company and then after the closing of the IPO, company announce the cut-off price i.e. issue price.
Companies prefer book building issues over fixed price issues as the former allows them to discover the price and demand.
The process of an IPO is very lengthy and there are so many compliances that a company needs to fill up to get listed on the stock exchange that’s why the issuer appoints intermediaries to help them out in this process.
As an investor, you must be watchful of the latest IPOs and have a clear understanding of financial metrics to grab the opportunity.
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