What is an Initial Public Offering (IPO): Everything Explained

IPO or initial public offering is a process that allows private companies to transform themselves into public corporations by selling a specific percentage of their companies' shares to investors.

A private corporation takes advantage of its high valuation and initiates an IPO to raise funds to finance future business operations. It also offers financial liquidity to existing investors and the company's founders. This article summarises the vital aspects of IPO. So, if you are curious to know about it, keep scrolling!

Usually, there are two components of IPO, and they are mentioned below:

1. Fresh Issue

A company issues new equity shares and sells these shares to willing investors. Through this, a company raises funds to utilise the money as per the objective for filing an IPO.

2. Offer for Sale

Existing investors of a company sell its shares. Here, the company does not get the money raised by selling these shares. However, it does not dilute a company’s equity share.

The two types of initial public offering are as follows:

1. Fixed Price Offering

A company considers its financial position, assets and liabilities and determines a price to offer its shares to investors. Investors are aware of the stock price before a company becomes a public corporation. Once the offerings are closed, investors become aware of the stock's demand in the market. Individuals need to pay the full price of the share while applying for this offering.

2. Book Building Offering

A company that initiates an IPO provides a price band of 20% on shares to investors. The willing investors bid on the stocks before their price is finalised and bidding is closed. Investors must state the number of shares they wish to purchase and the price they are interested in paying for each share.

As mentioned earlier, there is a price band in the book building offering. The lowest price of the share is the floor price. At the same time, the highest price of the share is the cap price. The final price is fixed after evaluating the investor bids.

Companies need to follow the following guidelines as directed by SEBI:

Profit Routes

• A company's net tangible assets must be worth ₹3 crores in every financial year of the past 3 years. The cash or cash equivalents such as account receivables, investment account or money in an account should not exceed 50%. However, this guideline is not applicable when a company initiates IPO through an offer for sale.
• The company's net worth must be ₹1 crore in every financial year of the previous 3 years.
• A company's operating profit must be approximately ₹15 crores (pre-tax) in three financial years out of the previous 5 years.
• If a company adopts a new name, then 50% of its revenue made in the past 1 year must have been generated after adopting that new name.
• The issue size's value in a company's IPO should be less than 5 times the company's net worth before initiating an IPO.

Non-Profit Routes

SEBI offers a QIB route for companies that cannot meet the strict profitability guidelines. In this, a company initiates an IPO through book building offerings. A company must allot 75% of the issue size out of the total offerings to Qualified Institutional Buyers. Remember that a company needs to refund the total IPO subscription money if it fails to meet this allotment criterion.

Here are some of the additional requirements that a company need to fulfil to initiate an IPO:

Prerequisites Set by NSE

• NSE demands the previous 3 year's yearly reports of a company that wishes to be listed on the stock exchange.
• A company should not be referred to the National Company Law Appellate Tribunal or National Company Law Tribunal.
• A company's net worth should not be negative.
• The company must have paid equity capital which should not be lower than ₹10 crores. In addition, the equity market capitalisation should not be lower than 25 crores.

Prerequisites Set by SEBI for Directors

Individuals who must have worked in similar lines of business for a minimum of 3 years and must own a post IPO equity share of 20% shall be regarded as promoters. One or more than one individual can share this 20%.

Prerequisites for Shareholders, Founders and Directors

• A company cannot initiate an IPO and get listed on the stock exchange if its directors serve debarment time. This is not applicable after the expiry of debarment time on the date of filing for an IPO.
• SEBI can reject the company's DRHP if these individuals who are promoters of this company have been denied from entering the market.
• If banks or other financial institutions label these individuals as defaulters, then a company cannot initiate an IPO with such defaulters. They either need to pay the outstanding debts or discharge them as directors or promoters.
• Promoters or directors must not be specified as fugitives based on Fugitive Economic Offenders Act 2018.

SEBI can reject a companies' DRHP if any of the following cases occurs:

• The promoters of a company filing for IPO is still unknown.
• The purpose of raising funds through IPO is not clear in DRHP
• A company's business model is not clear to investors
• The clarification regarding a sudden increase in a company's sales before initiating an IPO is unclear.
• The company is undergoing litigation, and its existence depends on the judgment.

Willing investors must take a look at the investment process in the initial public offering mentioned below:

Step 1: Decision-making

Experienced investors may not find it challenging to decide which IPO to apply for. Budding investors, in this case, can go through a company's prospectus. This prospectus summarises a company's business model and objective to file for an IPO. This information helps individuals to make informed decisions.

Step 2: Arrange Funds

Investors can utilise their existing funds to purchase the company's shares. Alternatively, they can also borrow a loan from financial institutions against an affordable interest rate.

Step 3: Open Demat Account

Investors need to open a Demat account to electronically keep shares and additional financial securities. They only need to provide a few documents such as an Aadhaar card, PAN card, etc.

Step 4: Application Procedure

Individuals can apply for an initial public offering through their trading or bank accounts. Some financial institutions also allow combining trading, bank and Demat accounts.

Investors must know about the Application Supported by Bank Account. This is mandatory as it allows banks to store the funds in an individual’s bank accounts. Individuals need to provide their Demat account number, bank account number, bidding information, and PAN card details in an ASBA application form to avail this service.

Step 5: Start Bidding

Investors need to bid as per the lot size, which is the minimum number of shares that individuals wish to purchase in an IPO. Then, investors bid within a price range. Individuals can also make changes in their bidding. At the same time, they need to remember that funds need to be blocked during bidding. The amount arrested in a bank account makes interest till the allotment process begins.

Step 6: Allotment Procedure

The stock's demand may be higher than those issued in the secondary market. As a result, selected individuals can also get fewer shares than they demand. In this case, banks often release the arrested funds partially or fully.

However, if an individual receives full allotment, he or she will get a Confirmatory Allotment Note within 6 working days of the IPO process. After the allotment of shares is complete, the shares are credited to an individual's Demat account.

Finally, investors need to wait for 7 working days to get the stocks listed on the stock exchange. It is usually completed after finalising shares.

Here are some of the following terms that are associated with an IPO that individuals must be aware of:

• Issuer: It implies the company that wants to issue shares on the stock exchange to raise capital for its business.
• Underwriter: A banker, merchant, or broker can be an underwriter to help a corporation underwrite its stocks.
• Draft Red Herring Prospectus: A DRHP is a document that allows investors to know about the company's listing on the stock exchange after being approved by SEBI. This document summarises information like the objective of raising funds from the public, the company's balance sheet etc.
• Oversubscription and Under Subscription: Oversubscription implies a market condition when there are fewer stocks issued for the public than the shares which investors have applied for.

Under subscription denotes a condition when the number of shares that investors have applied for is less than shares issued.

• Green Shoe Option: It is an over-allotment option and an agreement that allows an underwriter to sell shares more than a company has planned.
• Book Building: When an underwriter fixes a price at which a company will issue shares in an IPO, it is known as book building.

Enjoy the following benefits of investing in IPO are:

• Grow Existing Savings: Budding investors can start by investing in a company filed for IPO, which has the potential to grow in future. This will help them reap the company's success and grow their savings.
• High Returns in the Long-Term: Individuals can meet long-term financial goals as investing in an IPO means investing in equity. This equity investment brings higher returns in the long term, allowing them to plan for their retirement or purchase a house.
• Transparency in Share Prices: Investment in an IPO ensures transparency in share price. The share prices are mentioned in the IPO order document, and investors share access to this document like any other experienced investor. In the post -IPO, the share price will rely on the varying market rates and the best possible deal that a share broker can extend.