When you are browsing through the pages of the newspaper, you see an announcement of an IPO offering by a company. If you are among the people who are wondering what is IPO or what is the meaning of IPO? Here, we guide you through the basics of the term and concepts around it.
IPO Meaning/Definition
IPO means Initial Public Offering. It is a process by which a privately held company becomes a publicly-traded company by offering its shares to the public for the first time. A private company that has a handful of shareholders shares the ownership by going public by trading its shares. Through the IPO, the company gets its name listed on the stock exchange.
How Does a Company Offer an IPO?
A company before it becomes public hires an investment bank to handle the IPO. The investment bank and the company work out the financial details of the IPO in the underwriting agreement. Later, along with the underwriting agreement, they file the registration statement with SEC. SEC scrutinizes the disclosed information and if found right, it allows a date to announce the IPO.
Why Does a Company Offer an IPO?
1. Offering an IPO is a money-making exercise. Every company needs money, it may be to expand, to improve their business, to better the infrastructure, to repay loans, etc
2. Trading stocks in the open market mean increased liquidity. It opens door to employee stock ownership plans like stock options and other compensation plans, which attracts the talents in the cream layer
3. A company going public means that the brand has gained enough success to get its name flashed in the stock exchanges. It is a matter of credibility and pride to any company
4. In a demanding market, a public company can always issue more stocks. This will pave the way to acquisitions and mergers as the stocks can be issued as a part of the deal
Types of IPOs
If you are a new investor, you may find all the jargon around an initial public offering a little baffling. To clear your confusion, there are two major categories of IPOs offered by companies.
Fixed Price Offering
Fixed price offering is pretty straightforward. The company announces the price of the initial public offering in advance. So, when you partake in a fixed price initial public offering, you agree to pay in full.
Book Building Offering
In book building offering, the stock price is offered in a 20 percent band, and interested investors place their bid. The lower level of the price band is called the floor price, and the upper limit, cap price. Investors bid for the number of shares and the price they want to pay. It allows the company to test interest for the initial public offering among investors before the final price is declared.
Should You Invest in an IPO?
Deciding whether to put your money into an IPO of a relatively new company is indeed tricky. Being a skeptic is a positive attitude to have in the stock market.
Background checks
The Company obviously does not have enough historical data to back your decision, because it is just going public now. The red herring is the data on the IPO details which is provided in the prospectus, you need to scrutinize it. Know about the fund management team and their plans for IPO generated fund utilization.
Who is Underwriting
The process of underwriting is raising investments by issuing new securities. Be cagey of the underwriting of small investment banks. They may be willing to underwrite any company. Usually, an IPO with a success potential is backed by big brokerages that have the ability to endorse a new issue well.
Lock-up Periods
Often IPO takes a deep downtrend after the IPO goes public. The reason behind this fall of the share price is the lock-up period. A lock-up period is a contractual caveat which refers to a period of time the company’s executives and investors are not supposed to sell their shares. After the lock-up period ends, the share price experiences a drop in its price.
Flipping
People who buy stocks of the company going public and sell off on the secondary market in the view to get quick money are called flippers. Flipping initiates the trading activity.
IPO Advantages and Disadvantages
There are both advantages and disadvantages to investing in IPOs. You should be aware of them both to make an informed decision.
Advantages of IPO Investment
There are 5 potential benefits of IPO investment.
Access to a growing company: When a company receives fresh cash flow through an IPO and hits the growth path, it creates more value for investors. Companies that go public usually have higher growth prospects and ambitious expansion plans.
An Initial Public Offering allows you to become an early shareholder, and you can benefit from the company’s growth trajectory. Historically, successful IPOs have generated substantial returns for early investors, making them attractive investment options.
Access to innovative companies: IPOs give you access to invest in new and innovative companies that are pioneers in implementing technological advancements, bringing new products, services, or business models to the market. Investing in such companies allows investors to participate in growing, cutting-edge businesses with the potential to reshape the industry. By identifying promising companies, you can capitalise on transformative trends and industry shifts.
Liquidity and marketability: Becoming a public company improves the liquidity and marketability of the company’s shares. When the company becomes public, its investors can buy and sell stocks in the stock market.
Diversification: Including IPOs in your portfolio contributes to diversification, which is a critical risk management strategy. IPOs allow investors to expand their investments into new companies and beyond their existing holdings.
Diversification lowers the concentration risk associated with investing in a single company or sector and improves return potential.
Early entry discount: Through an IPO, you can invest in a company at an early stage, which gives you access to buy shares at a lower rate than the post-IPO market price. The early entry offers an advantage and the potential for higher returns in the long run.
Disadvantages of IPO Investment
Volatilities and uncertainties: Although IPOs offer opportunities to invest in innovative and growing companies, they are also highly volatile investment assets and, therefore, risky. In the absence of reliable performance and financial data, the risk of failing to assess the full potential of the company is high.
Limited information: Investors investing in new companies often need to deal with limited information. Private companies are not obligated to disclose the same level of financial and operational details as publicly traded organisations. The lack of information can be challenging for investors to thoroughly evaluate the company’s fundamentals, competitive landscape, and long-term prospects.
Lock-in period: The lock-in period may prevent you from selling the IPO shares after listing.
It is typically a cooling phase when certain shareholders, such as company insiders and venture capitalists, are restricted from selling their holdings. After the lock-in period, which can last from a few months to a few years, investors may face a decline in the share price due to an oversupply of shares in the market. Hence, it is important to carefully consider the lock-in period and its potential impact on the share price before investing in an IPO.
Things you should know before investing in IPO
1. If you have bought an IPO for the company, you are exposed to the fortunes of that company. You bear a direct impact on its success and loss
2. It is this asset of your portfolio which has the highest potential to reward the returns. On the flip side, it can sink your investment without a sign. Remember stocks are subjected to the volatility of the markets
3. You should know that a company which offers its shares to the public is not indebted to reimburse the capital to the public investors
4. You should weigh up your potential risks and rewards before investing in an IPO. If you are a novice, read up an account from an expert or a wealth management firm. If still in doubt, talk to your personal financial advisor
How to Apply for IPOs?
Nowadays, it has become easier to apply for an initial public offering because of the online application process. However, if you are a new investor, you need to learn a few things before applying.
The first important thing is funding. Whether it is a fixed price or a book building IPO, you will have to make a payment in advance, and for that, you must have funding ready. Investors can use their savings or take a loan from a bank or NBFC for the purpose.
However, without a DEMAT account, you can’t invest in stocks. So, the next thing you need is to open a DEMAT account. Select a reputed broker with a track record to have a DEMAT.
You can use the DEMAT account not only for IPOs, but to receive all sorts of investment instruments like gold bonds, corporate bonds, shares, and more.
The online process is an easy way to apply. You can do it from the investor portal on the broker’s website or by downloading the ASBA form from your bank’s net-banking platform.
ASBA stands for Application Supported by Blocked Account (ASBA). It allows banks to block funds in the applicant’s account against your bidding for the IPO.
If you apply through the broker, you need to use UPI enabled payment gateways to make payment. In either case, cheques and demand draft payments are not accepted for bidding.
Terms Associated With an IPO
There are several terms associated with an IPO, and as an investor, you need to be aware of those terms and their meanings:
- Prospectus: It is a legal document that provides details about the company, its financials, risks, and the offering. It’s distributed to potential investors to help them make informed decisions.
- Underwriter: A financial institution or investment bank that helps the company go public by purchasing the shares and reselling them to the public.
- Offer price: The price at which a company’s shares are offered to the public during the IPO. It’s determined through a process called book-building.
- Book-building: A process of determining the offer price based on the demand from investors. It helps in setting a fair market price for the shares.
- Allotment: It is the process of assigning shares to investors who have applied for shares during the IPO.
- Green Shoe Option (Over-allotment option): An option that allows underwriters to sell additional shares to the public if the demand is higher than anticipated.
- Listing: The process of a company’s shares being traded on a stock exchange, making them accessible to the general public.
- Lock-up period: A period after the IPO during which insiders (company founders, executives) are restricted from selling their shares.
- Grey market: A market where shares of a company about to go public are traded before the official listing. It indicates the potential listing price.
- Offer for Sale (OFS): A method of selling shares in which existing shareholders (promoters or other investors) sell their shares to the public, and the company doesn’t receive the proceeds.
- IPO subscription: The process of investors applying for shares in an IPO, indicating their interest and the number of shares they wish to buy.
- IPO registrar: A company responsible for processing applications, allocating shares, and managing the refund process for the IPO.
- Listing agreement: A contract between a company and a stock exchange detailing the obligations and requirements of the listed company.
- Flipping: It refers to selling the shares acquired during the IPO shortly after they start trading on the secondary market, typically to make a quick profit.
Eligibility Criteria to Invest in an IPO
If you are planning to invest in an IPO, ensure you fit into the eligibility criteria below:
- Must hold a PAN card.
- Have a valid Demat account.
- Though a trading account is not needed to apply for an IPO, you need a trading account if you want to sell the share after it gets listed.
Conclusion
Whether or not to invest in an initial public offering is a choice of an investor, but it is one way to accentuate the earning potential of your investment. Picking the right IPO offer to pose a bit of a challenge, but if you successfully overcome it, IPOs could be the most vital asset in your portfolio.
FAQs
What is an IPO?
IPO definition: IPO, or Initial Public Offering, refers to a process by which a private company becomes a publicly traded and listed company. During the IPO, the company offers its shares to regular investors for the first time and invites them to invest in the business. Through an IPO, a company raises capital from outside investors, and in turn, the investors become its shareholders.
How to invest in an IPO?
Investors can buy IPO shares using their Demat account. If you are an Angel One investor, follow the steps below to participate in an initial public offering.
- Log in to your investor account on Angel One
- Navigate to the IPO section and find the live IPOs
- Fill in your bid details along with UPI payment information
- Complete the bid by making payment on UPI
What are the types of IPOs?
There are two common types of IPOs: book-building and fixed price.
In book-building IPO, the company mentions a price range for the IPO shares. The lowest price band is called the floor price, and the upper limit is called the cap price. The company calculates the final price of the IPO shares based on the average bid received from investors.
For fixed price issues, the company declares the price at which the IPO shares will be available to investors.
