What is an IPO? How an Initial Public Offering Works

The world has been bullish on the Indian economy, especially in the post-COVID era. This optimism is evident in the record-breaking performance of Indian stock markets, with the Sensex crossing 80,000 for the first time in July 2024. This bullish sentiment has revitalised the IPO market, with numerous companies aiming to raise capital through the Initial Public Offerings route (IPO) in recent years.

Understanding an IPO and how to apply for one is crucial for new investors. Here's a brief insight into IPOs and their related details.

What is an IPO?

A company can raise capital for its financial needs through two avenues: debt or equity. An Initial Public Offering (IPO) is when the company raises capital through equity by offering its shares for public subscription for the first time.

Under this process, the company invites retail and institutional investors to own a portion of its equity and help generate capital for growth, paying off debt or funding other business initiatives.

SEBI and stock exchange norms govern a company's eligibility for an IPO and the IPO process. Investing in an IPO can provide an early bird benefit for investors, as they can gain through early participation in the growth story of companies with strong fundamentals and potential for growth in the long term or benefit from listing gains. On the other hand, companies benefit from the increased influx of capital and liquidity of shares for existing shareholders. 

How does an Initial Public Offering (IPO) Work?

The Initial Public Offering (IPO) is a process by which a private company becomes a public company. This article explains the steps to understanding how an IPO works.

• Initial Preparation

The company planning to go public hires investment banks to underwrite the IPO process. They help in preparing the necessary documents, including the Draft Red Herring Prospectus (DRHP), which details the company's financials, business model, risks, and other essential information. This document is submitted to the Securities and Exchange Board of India (SEBI) for approval.

• Approval from SEBI

SEBI reviews the DHRP to ensure all regulatory requirements are met and the disclosures are sufficient for investors to make informed decisions. Any changes SEBI recommends are then accommodated to finalise the RHP (Red Herring Prospectus) and presented for approval again. Once SEBI approves, the company can proceed with the IPO.

• Marketing

The company and its underwriters promote the IPO through roadshows and advertising to generate interest among potential investors. This helps gauge demand and attract a diverse pool of investors.

• Issue Pricing

The company, along with the underwriters, then decides on the issue price of the IPO. An IPO can be either a fixed-price IPO or a boom-building IPO, where the investors bid for shares within the price range, called the price band. The final price is determined based on the bids received at the close of the IPO.  

• Subscription

The subscription period of the IPO, which is usually three days, is when the investors (retail investors, HNIs, or institutional investors) apply for the IPO in the notified lots and pay the price through ASBA or UPI. As per the SEBI rules, a portion of the shares is reserved for different categories of investors.

• Allotment

Once the subscription period ends, shares are allotted to investors. If the IPO is oversubscribed, the shares are distributed proportionately or through a lottery system, and refunds are processed for those who do not receive shares.

• Listing 

The company shares are finally listed on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) after the allocation is completed. Investors can benefit from listing gains once the shares are listed on the stock exchanges, and existing shareholders can also benefit from increased liquidity. The share prices fluctuate based on the demand and supply forces of the market, and the company is obligated to adhere to the various reporting and disclosure norms set by SEBI, Companies Act 2013 and related laws.  

Types of IPO

There are two types of IPOs based on how the IPO is priced. Here is a brief description of the types of IPOs for better understanding. 

• Fixed Price IPO

A Fixed-price IPO is where the company sets the issue price specifically, and it becomes the price at which the shares will be offered to the public for subscription. This price is determined by the company and its underwriters based on factors like company valuation, financial performance, etc. It is mentioned in the RHP so that the investors can make an informed decision. However, the main drawback of this type of IPO is that it may not accurately reflect market demand, potentially leading to underpricing or overpricing of shares.

• Book Building IPO

On the other hand, the book-building process is where the price of the shares is not fixed but determined through bidding. The company provides a price band in the RHP within which investors can place their bids for the shares and indicate the number of shares they are willing to buy and the price they are willing to pay. The final price is known as the cut-off price and is determined based on the bids received and the demand for the shares, which reflect the actual value of shares through the price discovery process. 

Advantages and Disadvantages of an IPO

IPOs are excellent investment opportunities for investors and open new avenues for companies. Here is a list of a few advantages and disadvantages of an IPO, highlighting their importance and shortcomings. 

What are the Timelines Involved in an IPO Process?

The IPO process involves various stages, and the duration varies based on company deliberations and strategic planning, as well as the tenure required for SEBI approvals. The general IPO timeline is mentioned hereunder. 

• Company decision to go public - duration varies based on internal deliberations preparation for IPO

• Preparation and filing of DHRP - 2 weeks

• SEBI approval - 4-8 weeks

• RHP submission - 2-3 weeks

• IPO launch - 3-4 days

• Allotment - 6 days after IPO closure

• Listing on stock exchanges - 3 days from closing of IPO closure

• Post - Issue activities - 2-3 weeks

  Conclusion

  Driven by the growing Indian economy, a record number of IPOs are being launched by Indian companies. It presents a great opportunity to invest in and capitalise on the growth of these companies. Easy access to IPO investments through online stock broking platforms has increased retail interest. However, as with any investment, it is important to conduct thorough research to know the possible risks involved before investing in an IPO.