IPO: Process, Advantages, Disadvantages

An initial public offering (IPO) refers to the process of offering shares of a private company to the public in a new stock issuance. Public share issuance allows a company to raise capital from the general investors. An Initial Public Offering, or IPO, is the first sale of stock by a company to the public.

A company can raise money by issuing either debt or equity. In case, the company chooses the equity route, the first such offering of equity shares to the public via a listing of the shares in the stock markets is called an IPO.

IPOs generally involve one or more investment banks known as underwriters. A company planning an IPO will typically select an underwriter or underwriters. They will also choose a stock exchange in which the shares will be issued and subsequently traded publicly.

The company which offers its shares, known as an ‘issuer’, does so with the help of investment banks. After IPO, the company’s shares are traded in an open market. Those shares can be further sold by investors through secondary market trading.

IPO Eligibility Norms for Companies

SEBI has stated the eligibility norms for companies planning an IPO which are as follows:

Entry Norm I (Profitability Route)

• Net tangible assets of at least Rs. 3 crore in each of the preceding 3 years. Not more than 50% should be in monetary assets.
• Minimum of Rs. 15 crores as average pre-tax operating profit in at least three years of the immediately preceding 5 years.
• The net worth of at least Rs. 1 crore in each of the preceding 3 full years.
• If there has been a change in the company’s name, at least 50% of the revenue for preceding one year should be from the new activity denoted by the new name.
• The issue size should not exceed 5 times the pre-issue net worth.

Alternatively Entry Norm II (QIB Route)

To provide sufficient flexibility and also to ensure that genuine companies are not limited from fundraising due to the strict parameters, SEBI has provided the alternative route to the companies not satisfying any of the above conditions:

The issue shall be through book building route, with at least 75% of the net offer to the public to be mandatory allotted to the Qualified Institutional Buyers (QIBs). The company has to refund the subscription money if the minimum subscription of QIBs is not attained.

For FPO’s

A listed issuer making a public issue (Further Public Offer i.e. FPO) is required to satisfy the following requirements:

(a) If the company has changed its name within the last one year, at least 50% revenue for the preceding 1 year should be from the activity suggested by the new name.

(b) The aggregate of the proposed issue and all previous issues made in the same financial year in terms of issue size does not exceed five times its pre-issue net worth as per the audited balance sheet of the preceding financial year.

Any listed company not fulfilling these conditions shall be eligible to make a public issue (i.e. FPO) by complying with QIB Route as specified for IPOs i.e. issue shall be through book building route, with at least 75% to be mandatory allotted to the Qualified Institutional Buyers (QIBs).

There is no entry norm for a listed company making a rights issue.

Registration with SEBI

All companies which want to go public should fill the S-1 form with SEBI. A company and its investment bank fill in the registration statement by providing all details related to the company’s finances and the IPO related information to SEBI. These are the details that need to be disclosed in the registration statement:

• The business strategy of the company
• Company’s fiscal records which include income statements and balance sheets
• The potential risks of the investment
• The stock offering
• A comparative analysis between the company’s financial situation and goals

Advantages of IPO

An IPO has several benefits for the previously private company:

• Enlarging and diversifying equity base
• Enabling cheaper access to capital
• Increasing exposure, prestige, and public image
• An increase in liquidity makes it possible for talented employees to be hired and retained
• the potential of return is higher so it facilitates acquisitions (if any)
• Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans (Business loan), etc.

Disadvantages of IPO

There are several disadvantages to an initial public offering:

• Significant legal, accounting, and marketing costs, many of which are ongoing
• The requirement to disclose financial and business information
• Meaningful time, effort and attention required of management
• The risk that required funding will not be raised
• Public dissemination of information which may be useful to competitors, suppliers, and customers.
• Risk of equity being bought by competition & loss of control

Who are underwriters and their Role

Investment banks send a few representatives to the company who want to sell their shares to the public in the market for the very first time. They work out the complete process for them, to ensure successful entry into the market. The amount of risk the underwriter takes depends on how he is compensated. There are two ways of underwriting.

• Bought deal – Here the underwriters buy all IPOs from the Company and they resell it to the investing public. The compensation is the difference in the selling and buying price. The entire risk of the IPO listing outcome is borne by the underwriters.
• Best effort deal – According to this deal, the underwriters make their best efforts to sell the issue to the investing public. They do not purchase any shares from the company. The compensation is fixed. And there is no risk for underwriters, but they will not gain anything even if the shares do well post a listing.

Underwriters and the IPO Process

Steps to an IPO include the following:

1. 1. Select an investment bank- The very first step in the IPO process is for the issuing company to choose an investment bank that will provide underwriting services. The investment bank is selected according to the following criteria:
      • • Reputation
        • The quality of research
        • Industry expertise
        • Prior relationship with the investment bank
   2. Due diligence and regulatory filings- Underwriting is the process through which an underwriter acts as a broker between the issuing company and the investing public to help in selling the initial set of shares. The following underwriting arrangements are available to the issuing company.
      • Firm Commitment: Under this agreement, the underwriter purchases the whole offer and resells the shares to the investing public. The firm underwriter guarantees the issuing company that a particular sum of money will be raised.
      • Best Efforts Agreement: The underwriter does not guarantee the amount that they will raise for the issuing company. It only sells the securities on behalf of the company.
      • Syndicate of Underwriters: Public offerings can be managed by one underwriter (sole managed) or by multiple managers. When there are multiple managers, one investment bank is selected as the lead or book-running manager. Under such an agreement, the lead investment bank forms a syndicate of underwriters by forming strategic alliances with other banks, each of which then sells a part of the IPO. Such an agreement arises when the lead investment bank wants to diversify the risk of an IPO among multiple banks.
   3. Pricing- On the day before the effective date, the issuing company and the underwriter decide the offer price and the number of shares to be sold. Deciding the offer price is important because it is the price at which the issuing company raises capital for itself. The following factors affect the offering price:
      • the company’s goal
      • condition of the market economy

      IPOs are often underpriced to ensure that the issue is fully subscribed/ oversubscribed by the public investors.

   4. Stabilization- After the issue has been brought to the market, the underwriter has to provide analyst recommendations, after-market stabilization and create a market for the stock issued. Stabilization activities can only be carried out for a short period – however, during this period, the underwriter has the freedom to trade and influence the price of the issue as prohibitions against price manipulation are suspended.
   5. Transition to Market Competition- The final stage of the IPO process, the transition to market competition, starts 25 days after the initial public offering. During this period, investors transition from relying on the mandated disclosures and prospectus to relying on the market forces for information regarding their shares. Underwriters can provide estimates regarding the earning and valuation of the issuing company. Thus, the underwriter assumes the roles of advisors and evaluators once the issue has been made.

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