Initial Public Offering (IPO) – Fundamentals | Requirement | Process

Table of Contents

1. Initial Public Offering (IPO) Fundamentals
2. What is an Initial Public Offering?
3. Requirement for Initial Public Offering
4. Process of Initial Public Offering
5. Conclusion

1. Initial Public Offering (IPO) Fundamentals

In the present times of increasing business and economic challenges, the growth of any entity is dependent upon its ability to innovate, provide competitive products and services to capture the market and more importantly its ability to flourish into new markets. Going for an Initial Public Offer (IPO) is an indication that the enterprise has progressed to a significant level in its relative market and industry. The enterprise/company decides to issue securities for various reasons; the crucial one being that of raising capital to fund organic growth or an acquisition or meet financial requirements for starting a venture or repaying debts or expansion and diversification of business.

2. What is an Initial Public Offering?

• An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance.
• An IPO allows a company to raise capital from public investors.
• The transition from a private to a public company can be an important time for private investors to fully realize gains from the investment as it typically includes a share premium for current private investors.
• Meanwhile, it allows public investors to participate in the offering.
• Companies must meet requirements by exchanges and the Securities and Exchange Commission (SEC) to hold an IPO.
• IPOs provide companies with an opportunity to obtain capital by offering shares through the primary market.
• Companies hire investment banks to market, gauge demand, set the IPO price and date, and more.

Initial Public Offer

• Fresh Issue
• Offer for Sale

3. Requirement for Initial Public Offering

To understand the requirement for a company to raise IPO, the stages of funding of a company need to be discussed as follows:

Stage 1: Promoter Funds

Stage 2: Angel Investors

Stage 3: Venture Capital and Private Equity (PE) Firms

Stage 4: Initial Public Offer (IPO)

For a company to raise funds viz, equity funds, when it has already raised the same from some private investors and such investors further don’t have the capacity to invest in the quantum of capital required by the company, funds are raised from the public, entailing scope for large number of investors via Initial Public Offering. IPO also opens the gateway for institutional investors like mutual funds, pension funds, etc. For tapping such big funds, IPO is introduced to enable the company to:

• Expand
• Pare down debt
• Provide exit to previous investors.

4. Process of Initial Public Offering

Step 1: Hire an Investment Bank

• The company hires a bank known as investment/merchant bank which assists the company in issuing the shares by deciding the dates, price, time and place of the shares to be offered.
• The company chooses the bank on the basis of reputation/credibility, quality of research for proper pricing, valuation and timing of shares to be issued, distribution expertise, prior relationships.

Step 2: Due Diligence & Filings

• Underwriting: Firm Commitment, Best Efforts Commitment, Syndicate Underwriting.
• Red Herring Prospectus is a document of the company consisting of the following details: business and promoter details, competitive advantage, capital structure, future business plans, risks and opportunities, past financial data, future growth predictions, etc. It helps maintain transparency with the investors/stakeholders of the company.
• Compliances & Filings

Step 3: Pricing

• Valuation of Company
• Issue Size
• Issue Price
• No. of Shares to be Issued
• Lot Size
• Minimum Investment

Step 4: Distribution

• Investment Bank makes distribution of shares between Institutional Investors, Non-institutional Investors and Retail Investors.
• For the purpose of proper distribution of shares, the merchant bank shall indulge into advertisement of the same.

Step 5: Share Allotment

• On the basis of share applications received from the investors, shares shall be alloted among them.
• In case of over-subscription of shares, shares shall be alloted on proportionate basis.

Step 6: Listing on Stock Exchange

• Company shall get listed on the respective stock exchange viz National/Bombay Stock Exchange (NSE/BSE) and shall follow the guidelines as prescribed by them.
• Listing with the stock exchange shall be done within 3 days from the closing date of the offer, thus, making very quick access to capital for the issuer company.

This can be understood in detail with the help of following example.

Hiring & Underwriting

ABC Toys Ltd. is a company that hires XYZ Capital as its merchant bank. XYZ Capital carries out the due diligence process for the company. Under this process, the bank shall carry out the process of underwriting for the company, giving a firm commitment viz, if it commits of raising Rs. 1,000 crores from the market, it assures the company that in case of any shortfall, the same amount shall be invested by the bank itself and in case of any gain, the same shall be the profit of the bank. Thus, in the process of firm commitment underwriting, XYZ Capital takes the issue of shares on behalf of ABC To1ys Ltd., bearing any gain/loss on its own.

Under best efforts commitment, XYZ Capital shall carry out the process of valuation, pricing and distribution for the company, without providing any guarantee about the response or subscription from the public.

Under syndicate underwriting, ABC Toys Ltd. desires of raising a huge amount of capital say Rs. 10,000 Crores, in such a scenario XYZ Capital shall form a syndicate for the underwriting process. XYZ Capital shall hire multiple banks/managers and allocate small amounts to each of them, say Rs. 1,000 Crores to bank A and so on and collectively all of them shall raise Rs. 10,000 Crores for the company. XYZ Capital being the main book manager/runner shall be called as the lead manager and the remaining banks shall be referred to as participant managers.

XYZ Capital shall also be responsible for making the Red Herring Prospectus of the company. Further, it shall also be responsible for all the compliances and filings of the company including SEBI guidelines, National Stock Exchange/Bombay Stock Exchange wherever the company gets listed, Securities Contract (Regulation) Act, Companies Act, etc.

Pricing

XYZ Capital is also responsible for the pricing of the company under which it shall value the company say for Rs. 10,000 Crores. The bank decides of raising 20% of the total valuation of the company, i.e., Rs. 2,000 Crores, thereby selling 20% of the total value of the company to the public and keeping 80% shares with the promoters and existing investors. Thus, issue size shall amount to Rs. 2,000 Crores. XYZ Capital decides of fixing the issue price at Rs. 200/- per share, thereby, the number of shares to be issued shall be 10 Crores. The minimum lot size fixed by the company that needs to be purchased by any investor is say 50 shares or multiples of 50, thus, minimum investment that can be done by any investor is Rs. 10,000 (50 shares * Rs. 200).

Distribution

Both ABC Toys Ltd. and XYZ Capital shall be involved in the process of marketing of shares of the company for proper distribution of the same among all the investors viz, Qualified Institutional Buyers, Non-Institutional Investors and Retail Investors.

Share Allotment

In the share allotment process, on receiving the applications from the investors, there may be a case of over-subscription of shares from the investors say 110% of the total issue. In such a scenario, ABC Toys Ltd. shall decide the number of shares to be allotted among the various category of investors.

Listing

Lastly, if the company gets listed on say Bombay Stock Exchange (BSE), it shall comply with all the regulations and guidelines of the same. If the closing date of the issue is 1^st October, the company shall get listed on the respective stock exchange within 3 days of such date i.e., by 4^th October.

5. Conclusion

When a company decides to issue an Initial Public Offer (IPO) in the market, it opens the prospects for high future growth, inviting public investors to get their hands on some shares of the company for the first time. IPOs are introduced at discounted prices, to attract a large audience and ensure bulk sales generating large number of buyers from the primary issuance. The underwriters play a crucial role for the company at the initial stage of the IPO, thus, paving way for a secure future of the company to raise additional funds in the secondary market at a later stage.