Survival, Profit & Growth, the three major objectives of Management. After achieving the first two objectives, the company moves on to the most difficult one – Growth. To grow, the company needs more money – Capital. The three major options to get funds that a company has are Retained Earnings, Debt Capital (Borrowing), and Equity (selling ownership). And in today’s blog, we’ll talk about how companies raise funds through Equity.
When a privately held unlisted company sells its stake or ownership (shares) to the general public, for the first time, at a predetermined price or price band, they are issuing an IPO. Initial Public Offering helps companies to “go public” and to get listed on a stock exchange by selling the shares in the primary market.
Why do companies plan to “Go Public”?
Although the main reason for a company to issue IPO and get listed on an exchange is to raise money, there are many direct and indirect advantages a firm can get after listing. Following are a few of them:
- IPOs help companies to get market exposure. When a not-so-famous company issues IPO, stock market investors start researching and analyzing the company’s financials and other data.
- The financials of the companies are more reliable and can be trusted because SEBI (Securities & Exchange Board of India) cross-check the quarterly and annual reports. If SEBI finds any company providing wrong information to investors, they will be penalized.
- Companies have additional leverage which can help them to raise funds through other means in the future.
- When a company gets listed, the existing investors get more liquidity.
- Listed companies have more market exposure, which increases the probability of the company to get a share in hedge funds and mutual funds.
But, one of the major disadvantages related to IPOs is that the companies lose their stake, which simply means loss of control. Since shareholders are treated as the owner of the company, the management needs to keep them happy. The most common problem that firms face is a contradiction between management and shareholders.
How do companies issue an IPO?
Step 1: Finding a friend
Firstly an unlisted company looks for the right investment banker as they act as an intermediate between the company and investors. The Company with the investment banker files the registration statement, which has all the data related to business. The company also has to justify how they are going to use the funds in the statement. The purpose of filing a registration statement is to disclose all the information to the investors.
Step 2: The Warning Prospectus
The investment banker with the company prepares the Red Herring Prospectus (RHP) according to Section 32 of the Companies Act. The prospectus contains price estimation per share and other details of IPO. The first page of the draft has a warning stating that this is not the final prospectus. That is the reason why we call it RED Herring Prospectus.
Step 3: The Cross-Checking
Now SEBI goes through all the documents and information submitted by the company and only after their approval, the company can decide the IPO date. After getting a green signal from SEBI, the company approaches the stock exchange they wish to get listed on.
Step 4: The Marketing Phase
After all the above stated legal work, the company moves on to market their IPO. The company uses presentations, facts and figures, and other data to attract investors. Companies also use print media to market the IPO.
Step 5: The Pricing Time
IPO price can be of two types:
1. Fixed Price Issue
- Book Building Issue
In Fixed Price Issue, as the name suggests, investors know the price per share in advance. But, in the Book Building Issue, the company provides a price range to investors. The investors have to place a bid for a price within the band.
Step 6: Mission Successful
Now, finally, IPO is launched, investors get the shares allotted to them within 10 working days. The company gets the fund and enters the secondary market.
The company divides investors into 3 categories, Non-Institutional Investors or High Net Worth Individuals, Qualified Institutional Buyers, and Retail (Individual) Investors.
You must have heard about the IRCTC IPO, an example of the most successful IPOs. Issued in 2019, it was oversubscribed by 112 times. The company used the Book Binding approach, setting the price band of 315 – 320. On their first day in the secondary market, they closed at 779.15 per share.
The Book Building Game
Mostly used pricing strategy nowadays for IPOs, the Book Building Issue, according to the SEBI guidelines, is defined as
a process undertaken by which a demand for the securities proposed to be issued by the Corporate body is elicited and built-up and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of, a notice, circular, advertisement, document or information, memoranda or offer document.
The main objective of the Book Building issue is to determine the actual demand and price of the stock. The Book Building approach uses the demand for the stock at different prices (within the price band), and finally concludes to a final IPO price. This method helps companies to reap benefits from rising prices and demand for the stock, while simultaneously reducing the chances of under subscription of IPOs.
What if the company is already listed on a stock exchange and again wants to raise money by selling its stake. Here comes the FPO.
FPO (Follow on/Further Public Offer) is defined as a process by which an already registered company issues more shares to the public to raise funds. The companies generally use FPOs to diversify their equity base or to raise money to pay the debt.
One of the most famous FPOs of 2020 so far has been the Yes Bank’s Offering. The bank raised Rs 14,272 crore through FPOs, which was around 95% subscribed. According to the guidelines provided by SEBI, if your FPO is not subscribed by at least 90%, you have to refund the entire subscription amount.
Know the Difference
Although one of the main aims of issuing an IPO or FPO is to raise funds, there are many differences between them, we need to be clear about. Following are a few of them:
- Investment in IPOs is riskier as compared to investments in FPOs. A reason for high risks in IPO is that there is no guarantee of getting shares, or getting less number of shares because of oversubscription, etc.
- In an IPO, the price is decided by the company, but in FPO, the prices are market-driven.
- Generally, IPOs are more expensive than FPOs. When a company declares the FPO news, the price of existing shares falls, because the number of shares is increasing (in the case of dilutive offering).
- In IPO, you get equity shares (most of the time) or preference shares. But in FPO, the company sells either Diluted shares or Non-Dilutive Shares.
- Investors prefer to invest in FPOs because the companies are already listed, they can judge them from their past performance.
IPOs and Retail Investors
Retail investors are generally provided 10-15% shares, if this percentage is oversubscribed, then the company distributes shares proportionally or uses the lottery method (in case of high oversubscriptions).
One of the most difficult tasks for any investor is to pick the right stock. But here are a few tips which can help you to identify the right company. First of all, you need to understand the business and the future of the industry business is working in. Retail investors can avoid those companies who are raising funds to clear their debt rather than using them for expansion or growth. You should also conduct deep research and analysis of the financials of the company, for which the data can be taken from the company’s prospectus.
The company provides the minimum and maximum lot size for which a retail investor can apply. For example, SBI Cards IPO, Book Building Issue price band of ₹750 – ₹755, with one lot of 19 shares, collectively amounting to ₹14,345, and a maximum of 13 lots (247 shares).
Most of the companies use a stock exchange which acts as a medium between retail investors and the IPO, where you can find all the documents related to the business and can place bids through their online Book Building IPO services.
When the question comes IPO v/s FPO, it completely depends on how much risk you are ready to take. IPOs are generally subscribed by experienced investors and institutions, and because of not knowing much about the company individual investors avoid IPOs. However, if you are willing to take risks and believe that the company is strong fundamentally you can surely invest in IPOs.Finding the right IPOs has always been a tough task, but IPOs do give you better returns if you know the art of picking the right ones.