What is IPO in Share/Stock market? Initial Public Offering: Types, Terms, Risks, Pros & Cons

Initial public offerings (IPOs) generate huge excitement in stock markets, offering opportunities for massive gains but also risks. This in-depth guide will equip you to analyze IPOs wisely and maximize your chances of allotment and profitability when companies go public.

Introduction

An IPO marks a pivotal moment in a private company’s journey. It is the first sale of shares to public investors on a stock exchange to raise capital and become publicly traded.

Mastering how IPOs work can give individual investors an edge when high-profile companies like Zomato, Paytm or Delhivery go public.

Equipped with this knowledge, you can avoid common IPO mistakes and invest strategically when lucrative IPO opportunities arise. Let’s get started!

What is IPO In Stock Markets?

An IPO, or Initial Public Offering, refers to the process by which a private company offers its shares to the public for the first time on a securities exchange like NSE or BSE.

Through an IPO, a company is able to raise significant capital from public markets for growth and expansion. The company essentially turns from a private entity into a publicly-traded company.

Up until the IPO, the company has been funded privately by its founders, investors and shareholders. The IPO opens up access to capital from public markets.

This event is also referred to as “going public”. It transforms a private company into a publicly-traded entity on an exchange like NSE or BSE.

What is an FPO?

A Follow-on Public Offering (FPO) is when a company that is already listed conducts a subsequent public offering of shares. The purpose is similar to raise additional capital from public markets.

Types of FPOs

• Rights Issue: Existing shareholders get the ‘right’ to purchase additional shares in proportion to their holdings.
• Preferential Allotment: Shares allotted to select investors rather than all shareholders.
• Institutional Placement Programme: Tailored for allotment to QIBs and other institutional investors.

Purpose of Going Public Via IPO

Here are some of the key reasons a company decides to go public:

• Raise large amounts of capital for growth and expansion
• Create liquidity for early investors and shareholders
• Enhance public image and brand visibility
• Tap wider investor base for future financing needs
• Public listing creates prestige and credibility
• Acquire companies through stock instead of cash

The influx of funds and public profile boost from an IPO can propel the company into a higher growth trajectory.

Funds raised via an IPO can be used for purposes like:

• Funding research and product development
• Expanding manufacturing and operations
• Acquiring assets or companies
• Repaying debt
• General working capital

An IPO also creates liquidity for early investors and shareholders, provides increased public visibility, and enhances prestige and credibility for the company.

How Does the IPO Process Work? Key Steps In An IPO Process

Let’s examine the major phases in the IPO process lifecycle:

1. Pre-IPO Preparation

• Company appoints lead managers, underwriters, auditors, lawyers
• Financial audits and due diligence activities commence
• Legal teams draft required IPO documentation
• Company leadership prepares roadshow presentation
• Securities filings submitted to SEBI for review

2. Regulatory Filings And Review

• Company files draft offer document: Draft Red Herring Prospectus (DRHP)
• SEBI reviews and provides observations on the DRHP
• Company addresses SEBI observations and files the updated Red Herring Prospectus (RHP)

The RHP contains all details about the company, risks, financials, management, business model, use of funds raised etc.

3. Marketing The IPO Roadshows

• Company management and underwriters arrange roadshows to showcase the IPO to institutional investors
• This is done to gauge potential demand and get investor feedback on pricing
• Analyst meetings are also conducted to make buy recommendations

4. Pricing The IPO

• Company and underwriters finalize the IPO price band based on regulatory guidelines, investor demand, market conditions etc.
• The final offer price is set at the upper or lower end of the price band
• Retail investors are allocated shares at the offer price

5. Allocation And Allotment

• Underwriters allocate shares to institutional and retail investors
• Largest portion is reserved for qualified institutional buyers (QIBs)
• Retail investors get around 10-35% allocation
• IPO shares get credited to investor DEMAT accounts

6. Listing And Trading

• IPO listing on the exchange happens within 6 days of the offer closing date
• Trading then commences on the public markets
• Share price discovers fair market value based on demand-supply

The IPO process can typically take 6-9 months from hiring underwriters to eventual listing and trading. The timelines vary depending on regulatory approvals and market conditions.

Once public, the company becomes subject to various continuing disclosure requirements:

• Quarterly 10-Q filings Quarterly earnings reports filed with the SEC.
• Annual 10-K filings Comprehensive annual financial reports filed with the SEC.
• Other material events Announcements of major events like mergers, CEO changes, etc.
• Shareholder meetings Regular shareholder meetings must be held.

Meeting these reporting rules is critical for maintaining transparency and trust with public shareholders. With proper IPO planning and execution, companies can access the public markets successfully. The ongoing requirements are simply the cost of doing business as a public entity.

Distinction from Secondary Market Trading

It is important to distinguish an IPO from secondary market trading. The IPO represents the first time a company’s shares are sold to public investors.

After the IPO, the company’s shares trade freely on exchanges between investors at market-determined prices. The IPO is a one-time event and marks the transition from private to public.

Trading an IPO

• IPO listing happens within 6 days of closing date. After this, trading on exchanges begins just like any other listed stock. Investors who got IPO allotment can sell shares after listing.
• IPOs are often oversubscribed, so allotment is not guaranteed. Flippers try to sell immediately after listing to book quick profits when trading begins.
• Factors impacting IPO price during trading include overall market conditions, industry trends, financial results, company reputation, growth outlook and more.
• Just like any stock, prices fluctuate minutely on demand-supply. IPOs typically see high volatility in early trading days.

Post-IPO Company Performance

The company’s market performance after listing depends on various factors:

• Delivering on projected financial growth
• Maintaining solid revenue visibility
• Adapting to added public disclosures and compliance
• Withstanding competition and industry disruption
• Handling market volatility and investor expectations

The management must continue executing strongly for the company to thrive in the public markets over the long-term.

IPO Allotment and Subscription Explained

Under high IPO demand, allotment is not guaranteed. Here are key things that influence the odds of allotment:

• Reservation Category: Retail investors have a higher chance in the retail portion. Employees get preference in employee reservation.
• Application Size: Higher bid amounts (based on lot size) increase chances compared to bidding for minimum lots.
• Past IPO Record: Frequent bidders and those with good past allotment history usually get preference.
• Payment Details: Accuracy in details like PAN, demat account, UPI ID etc boosts the application. Erroneous applications can get rejected.
• Oversubscription Levels: When an IPO gets heavily oversubscribed, even good applications may not get shares. Moderate oversubscription is ideal for allotment.

Risks And Challenges Of IPO Investing

While investing in IPOs can be lucrative, be aware of the distinct risks involved:

• Overvaluation: IPOs may be priced based on hype and growth projections vs fundamentals.
• Volatility: Newly listed stocks see wild price swings initially. Lock-in periods restrict exit options.
• Unproven Business: A relatively young business has risks and uncertainty vs established companies.
• Disclosure Failures: Inadequate due diligence increases chances of financial issues emerging later.
• Promoter Dumping: Promoters may sell their portion after listing, impacting share price.

Fixed Price vs Book Building IPOs

There are two main IPO offering methods:

• Fixed Price Offering: The company and underwriters determine the share price in advance and offer shares to investors at that fixed price.
• Book Building Offering: The final IPO price is set after gauging demand from institutional investors during the bidding process. Investors bid within a price band.

Book building is the more popular method as it helps discover the fair market price based on investor demand.

Types of Investors in IPOs

There are different classes of investors in IPOs:

• Retail Individual Investors (RIIs): Individual investors applying for up to Rs 2 lakhs.
• Non-Institutional Investors (NIIs): Individual applicants bidding for over Rs 2 lakhs.
• Qualified Institutional Buyers (QIBs): Institutional investors like mutual funds, banks etc.

QIBs get allocated the majority of IPO shares. RIIs get around 10-15% allocation.

Pros and Cons of an IPO

Advantages

• Raises capital for growth and operations
• Enhanced public profile and prestige
• Founders and early investors get liquidity, they can exit through sale of shares
• Wider investor base for future financing

Disadvantages

• Extensive regulatory requirements
• Increased public scrutiny and shareholder expectations
• Loss of confidentiality and control
• Higher costs like underwriting fees
• Short-term focus on quarterly results

Key Things to Remember

• Assess company’s financial health and valuation
• Review prospectus and disclosures thoroughly
• Understand wider market conditions impacting IPO
• Be wary of oversubscribed IPOs and hype
• Have long-term investment horizon

Alternatives to IPOs

Companies can also raise funds through:

• Venture Capital and Private Equity
• Debt Financing
• Crowdfunding Platforms
• Reverse Mergers
• Direct Public Offerings (DPOs)

IPOs effect on the Stock Market

Initial public offerings (IPOs) can have a major impact on the overall stock market when high-profile, fast-growing companies go public. Here are some of the key effects:

• Market Volatility

The launch of a major IPO can create volatility in the markets. When well-known tech “unicorns” like Zomato, Nykaa, PolicyBazaar etc go public, it generates a lot of enthusiasm and hype among investors. This can result in a spike in demand that whipsaws the share price above rational valuations. The volatility can have ripple effects across related sectors and the broader market.

• Investor Sentiment

The market sentiment surrounding anticipated IPOs can influence overall investor sentiment and perceptions of valuations. For example, the successful listing of a hot startup can fuel optimism and risk appetite. On the other hand, lackluster response to an offering may dampen broader market mood.

• Capital Flows

Large IPOs can soak up significant investor capital from the markets. The influx of investment funds into new public companies means less capital available for the rest of the market. This capital gets redirected based on the appetite for hyped IPOs rather than a rational allocation across assets.

• Due Diligence is Critical

Given the impact of IPOs on market volatility and valuations, it is extremely important for investors to conduct thorough due diligence. The hype around an IPO should not override rational analysis of the company’s financial health and valuations. Following the herd mentality without deeper analysis could lead to getting caught in a bubble.

By being aware of how IPOs can influence stock markets and maintaining diligence, investors can make wiser decisions when hot IPO opportunities come around. The hype shouldn’t overwhelm research into the fundamentals.

What is an SME IPO?

An SME IPO, or Small and Medium Enterprise Initial Public Offering, is when a small or medium-sized business conducts an initial public offering of its shares.

SMEs are defined as companies with relatively smaller scale operations compared to larger enterprises. The criteria for qualifying as an SME varies based on factors like revenue, profits, assets, and market capitalization.

SMEs and IPO Motivations

Here are some of the key reasons an SME may want to go public with an IPO:

• Raise capital for growth and expansion plans
• Create liquidity opportunities for early investors and shareholders
• Enhance public profile and credibility of the company
• Gain prestige and visibility as a listed entity
• Tap a wider investor base for future access to capital

Listing publicly also opens up possibilities like using company stock as currency for mergers and acquisitions.

Regulatory Accommodations

Securities regulators provide certain accommodations for SME IPOs to encourage small companies to list:

• Relaxed eligibility norms in terms of track record and profitability
• Reduced compliance requirements related to disclosures and governance
• Reserved SME exchange platforms with proportionate regulation
• Lower costs for issuers making the IPO more feasible

How to Invest in an IPO

Once a company files its IPO registration statement, the next key question is: how can investors get in on the offering? Here are some tips for investing in IPOs as an individual.

Applying for IPO Shares

The traditional way to get early access to IPO shares is through an underwriter allocation. IPO underwriters determine which institutional clients and high net worth individuals receive shares at the IPO price.

To get on an underwriter’s radar, you typically need at least a six-figure brokerage account and an active trading history. Maintaining a relationship with a stockbroker at a top underwriting firm also helps your chances of being allocated IPO shares.

Buying After Trading Starts

If you missed out on the underwriter allocation, another option is to buy shares on the open market after trading begins. However, expect to potentially pay a higher price than the IPO price, depending on initial trading activity and demand.

Setting limit orders can help control the price you pay if trying to buy post-IPO. You may have to wait out volatility in the early trading days before your order is filled.

Should You Invest in IPOs?

IPOs carry more risk than established public companies. The initial share price is based on estimated valuations, not proven performance. And stock prices can be especially volatile right after an IPO.

However, IPOs also offer the potential for hot returns. Some recent examples like Airbnb and DoorDash saw triple-digit first day pops. But these outsized gains are atypical.

As with any investment, assess the fundamentals, growth prospects, and valuation before jumping into a new IPO. Never invest based on hype alone. With thorough research and measured risk-taking, IPOs can potentially boost your portfolio’s overall returns.

Key IPO Terminology

Here are some common IPO terms useful to know:

• Underwriters: Investment banks that facilitate the IPO process
• Listing: Official inclusion of the company’s shares on a stock exchange after IPO
• Roadshow: Company presentations to institutional investors to build IPO interest
• Prospectus: Regulatory document filed with details of the IPO
• Allocation: Apportioning of IPO shares to eligible investors
• Market Capitalization: Value of all outstanding shares at the IPO price
• Flipping: Reselling IPO shares quickly to profit from price pops
• Lock-up period: Insiders cannot sell shares for set period

An Initial Public Offering (IPO) is the process by which a private company offers its shares to the public for the first time. There are different types of IPOs based on the offering method and investors targeted.

Conclusion:

The IPO process allows private companies to access public capital markets, but it requires extensive preparation and ongoing commitments. Here are some key takeaways:

• IPOs follow a lengthy step-by-step process, guided by investment banks. Expect 3-6 months from kickoff to offering.
• Companies must meet ongoing reporting rules and governance requirements once public. Quarterly and annual filings are mandatory.
• An IPO can generate capital for growth, liquidity for investors, and public profile. But it also means increased scrutiny.
• Alternatives like direct listings or SPACs may provide other paths to go public. An IPO is not the only option.

If you’re exploring an IPO for your high-growth private company, here are some tips:

• Thoroughly vet prospective underwriters for the best fit and experience. Ask for past client referrals.
• Build out your finance and legal teams well in advance. Financial controls and reporting are key.
• Get your house in order operationally. Tighten processes and procedures across the business.
• Plan for life post-IPO. What new strategies will support growth as a public firm?

It’s smart to consult with experts like investment banks, law firms, and accounting firms when weighing an IPO. They can guide you through the process and requirements. The SEC also provides helpful IPO resources and checklists for companies.

While an IPO has major advantages, it also brings costs in terms of time and money spent on the process and ongoing filings. Make sure your company is ready for this next chapter. With the right preparation, an IPO can successfully propel your business forward.

FAQs about IPOs:

Is an IPO a Good Investment?

IPOs can offer big growth potential, but they also carry more risk than established public companies. Do thorough research before investing to understand the business fundamentals and valuation.

How Is an IPO Priced?

IPO pricing is set through a process involving the company, underwriters, and institutional investors. Demand for the offering helps determine the final IPO share price.

Is IPO a Stock or a Share?

An IPO is the process of a company first offering shares of stock to the public. The shares sold in the IPO are common stock that trade on an exchange after the offering.

How is IPO Profit Calculated?

IPO profit is the difference between the IPO offer price and the current trading price. If you bought shares at $10 and the stock now trades at $30, your profit is $20 per share before fees.

What Do You Mean by IPO?

IPO stands for initial public offering. It is the process by which a private company sells shares to the public through a new stock issuance for the first time.

How Does an IPO Work?

The IPO process involves the company hiring investment banks, filing registration statements, marketing the offering to investors, setting a price, and ultimately listing and trading the shares publicly.

Is IPO Profitable?

Some IPOs generate big profits, but nothing is guaranteed. Investors should assess the valuation and growth prospects, not just assume high returns. Money can also be lost on IPOs.

How to Sell IPO Shares?

Once trading begins after the IPO, you can sell shares anytime through a brokerage account like any other public stock. Beware of lock-up periods that restrict insider sales.

How Long is the IPO Process?

A typical IPO process takes 3-6 months from hiring underwriters through to the stock listing and trading. But preparation often starts 1-2 years before the offering.

How is an IPO Priced?

See above IPO pricing typically happens just before shares start trading, based on investor demand indicated during the roadshow. The underwriters and company set the price.

Can Anybody Invest in an IPO?

Retail investors can buy shares once trading starts, but getting the IPO price requires an underwriter allocation, usually reserved for institutions and high net worth clients.

Is IPO More Profitable Than FPO?

Returns vary. IPOs involve more uncertainty as newly public companies. Follow-on public offerings (FPOs) for already listed companies may offer more predictable returns.

How Do I Find New IPO Stocks?

Upcoming and recent IPOs are listed on major stock exchanges and financial news sites. You can also check underwriter calendars for expected offerings.

What Does Non-Dilutive FPO Mean?

A non-dilutive follow-on public offering is when an already public company sells more shares without diluting existing shareholders’ stakes.

What is the Primary Objective of an IPO?

The main goals of an IPO are to raise capital for the company’s growth, create liquidity for shareholders, and establish a public market for the stock.

How Much Does an IPO Cost?

IPO costs include underwriting fees (~4-7% of proceeds) plus auditing, legal, registration, roadshow marketing, and other expenses. Total costs often reach $1 million or more.

How is the IPO Price Calculated?

The IPO price aims to balance maximizing proceeds for the company while still attracting sufficient investor demand. Underwriters gauge this demand during the marketing process.

Also Read: How to heck IPO allotment status?