What is an Initial Public Offering (IPO)
In this post we will understand about Initial Public Offer in which we will learn how a Private Ltd. company becomes a Public Ltd. company.
Before we discuss about initial public offering let’s understand how a typical company forms from the scratch through an example.
Let us assume there is a guy named Arvind who wants to open a Company in India. Now Arvind has a very good business idea and he wants to open an E-Commerce company where he wants to sell shoes online as he feels that there is very less competition in this sector and he can exploit this opportunity. But the main problem is that Arvind has no funds to implement his business idea. So Arvind decides to take loan from Bank but unfortunately, he has no Collateral available so the banks reject Arvind’s Loan request.
Now Arvind has two options either to forget about his idea completely or go to his family and friends and ask for some funds. Fortunately, Arvind’s two friends like his idea of selling shoes online and thus agree to invest funds in his company. So Arvind forms a Private Limited Company and distribute shares of that company equally between him and his two friends.
Since Arvind’s friends have funded into the company before the business has started they would be called as Angel investors. And the funding provided by the Angel Investors is called Seed Funding.
Now Arvind starts his business and very soon his business flourishes and becomes a good success in a span of 2 years.
Now Arvind decides to expand his business and therefore he wants to sell online Electronic items along with Shoes. Now Arvind requires 10 Crore rupees to expand his business.
Arvind already has a successful business which is generating good profits and thus he decides to go to some Venture Capitalist to raise funds for his company. Two venture capitalists (VCs) are interested in Arvind’s business and raise their hands to invest capital into his company. In return Arvind decides to give a percentage of shares of his company to the two Venture Capitalists (VCs).
Venture Capitalist is an investor who invest in the early stages of a business and the funding provided by the VC is called Series A funding.
Now after 5 years Arvind’s company has attained rich valuations generating huge revenue.
Now Arvind has a desire to once again expand his business to other categories such as to open a Fashion e-Store. To open a Fashion e-store Arvind requires a capital of 30 Crore Rupees.
Now Arvind has two options, either to go to a Venture Capitalist or to a Bank to raise funds. Since Arvind’s Business is already generating good profits a Bank would certainly not deny Arvind’s Loan Request and would happily give him a Loan of 30 Crores. In financial terms this loan given by Bank is called Debt.
Now 7 years have passed and Arvind has become a success in Fashion e-store and now wants to again expand his business into other categories. This Expansion of business by raising funds is called Capital Expenditure or CAPEX in financial terms.
Now Arvind wants to sell everything like electronic goods, clothes, books, furniture etc. on his e-commerce platform. Beholding this he requires a CAPEX of 80 Crore rupees.
Since the Capital Expenditure (CAPEX) amount is large this time, Arvind decides to go to Private Equity (PE) investors who are professionally qualified investors with a large appetite for investing. These type of investors generally exist as a firm and mostly invest in a well-established business which are generating good revenues. This funding can be called as Series C Funding as this type of funding is done when the business is already a success and is generating good profits.
After 17 years Arvind’s company has now become a huge success in India. Now Arvind wants to expand his company operations to other parts of the world. Beholding this CAPEX requirement, Arvind needs 300 Crore Rupees to expand his operations around the Globe.
This is where Arvind makes a decision to take his company Public.
Now before moving further let’s answer some questions.
Question: How company goes public?
Answer: A company goes public through Initial Public Offer.
Question: What is Initial Public Offer?
Answer: An Initial Public Offer (IPO) is the first time that the stock of a private company is offered to the public.
Now since the company is offering the shares first time to the public at a particular offer price called Public Offer Price (POP), this whole process is called Initial Public Offering (IPO).
IPO Process in detail :
There are several pros and cons when a company goes public through IPO. Every company who does that has to follow some rules and regulations when it goes public.
The first public offer of shares made by a company is called an initial public offer. In IPO the shares of the company becomes widely held both by public and promoters and thus, there is a change in the Share Holding Pattern. The shares which were privately held by promoters are now held by retail investors, institutions, promoters etc. An IPO can either be a fresh issue of shares by the company or it can be an offer for sale to the public by any of the existing shareholders such as the promoters of Financial Institutions or a combination of the two.
- Fresh issue of the shares: New shares are issued by the company to public investors. The issued share capital of the company increases. Percentage of existing shareholders comes down due to the issuance of new shares.
- Offer for sale: It is a process in which an existing share holder of a company decides to sell his folding to the public investors. Capital of the company does not change since the company is not making a new issue of the chairs. The proceeds of the IPO go to the existing share holder who is selling his shares and not to the company.
A company has issued 1,00,000 shares of face value Rs. 10 each. The shares are equally held by promoters A and B that is each promoter has 50,000 shares of the company.
Let’s look at the two scenarios to understand this concept clearly.
Scenario 1: Fresh issue
The company decides to make a fresh issue of 50,000 shares which means 25,000 additional new shares of each promoter is given to the public.
Now after IPO, Total shares of a company becomes 1,50,000 shares of face value Rs. 10 each.
The percentage holding of each Promoter will change from 50% to 33.33% that is each promoter have 50,000 shares and remaining 50,000 shares of total 1,50,000 shares are held by public.
Scenario 2: Offer for Sale
The company decides to make offer for sale of 50,000 shares which means 25,000 shares of each promoter is given to the public.
Now after IPO, a company will remain at 1,00,000 shares with a face value of Rs. 10 each.
But the holding of the promoters will decrease to 25,000 shares each from 50,000 shares each pre-issue of IPO. The percentage holding of each promoter will change from 50% to 25% that is each promoter now only have 25,000 shares and remaining 50,000 shares of total 1,00,000 shares are held by public.
The money raised in the IPO will go to the promoters who have sold their shares and not to the company.
How pricing of a public issue of shares is done?
Each and everything in the IPO has to be done under the guidelines of SEBI. SEBI’s regulations allow an issuer to decide the price at which shares of the company will be offered to public also called Public Offer Price (POP).
Public offer price can either be fixed by the issuer or can be determined by the process of bidding by investors. Let’s understand each method to determine the price of public issue of shares in detail:
- Fixed price issue: In Fixed price issue of shares to the public the company decides fixed price at which the shares will be issued to the general public and this is done with the help of a merchant banker who is also called lead manager. The price is selected by doing the valuation of the company and also the share prices of peer companies in the market. The price at which shares will be allotted to the public is informed well in advance so that the investors know the price at which the company is going to allot that shares to the public.
- Book Built Issue: The main aim of book built issue is to determine the price at which market is willing to pay for the shares issued by the company. In this, the shares are allotted to the public in a Price Band within which investors can bid. When the issue opens for general public, investors can bid a price within price band. The Price bid should be above the floor price which is the minimum price of the price band. When the issue closes the cut off price is decided by the company in consultation with Merchant Banker. All the allottees who bid above the cut-off price are granted shares and those who bid below the cut-off price are not given any shares and their money is refunded back to them.
Let’s understand this through an example :
A company wants to issue 10,000 shares through a book built offer within price band of Rs. 100/- to Rs. 120/-. In this Rs. 100 is called floor price that is all bid should be above this price. The bid received as follows:
|Price||No. of Shares||Total Demand|
The offer is filled up at the cut off price Rs. 112. All investors who paid at this price or higher are eligible for allotment in their respective categories. A company has the leverage to decide the cut off price lower than this price so that all investors can be benefited.
Now let’s go back to our previous example of Arvind who decided to go Public through Initial Public Offering.
Question: Why Arvind decided to go public?
Answer: The reasons can be:
- He wanted to expand his business in all over the world so as to meet the CAPEX requirement which was quite higher this time, (300 Crore Rupees). So the only option left to Arvind was to let his company go public through Initial Public Offering.
- This also gave an opportunity to Arvind to reduce his company’s Debt burdens as now he can utilise the proceeds of IPO to settle his short-term and long-term debts.
But before Arvind applies for IPO he needs to appoint a Merchant Banker who can assist Arvind and his company with various formalities that needs to be completed before a company goes public.
Merchant banker also called Book running Lead Managers / Lead Manager helps a company in preparing various listing documents including Draft Red Herring Prospectus and also underwrite shares which means they can buy all or part of the shares of the company and resell them again to the public which they generally do by adopting some marketing strategies.
Breaking down the steps of Initial Public offering – IPO :
- Merchant Banker is appointed which facilitates preparation of documents and other formalities which company needs to prepare before going public.
- An application is sent to SEBI to apply for IPO.
- After getting approval from the SEBI for the IPO, company needs to prepare DRHP also called Draft Red Herring Prospectus which consists of every information of a company including financial performance, future operations, the size of the IPO, number of shares offer to the public and the day when the company will list its shares to the public.
- Company decides to issue shares at either Fixed Price or Book Built Issue.
- The issue may be over- subscribed which means the bids made at cut-off price or above cut-off price were higher in numbers. Those who bid at or above cut-off prices are allotted shares of the company and those who bid below cut-off prices are granted full refund of their application amount.
- A date is chosen by the company on which shares will be listed on the Stock exchange.
- From listing day, the shares of company start getting traded at respective Stock Exchanges.
Points to Remember :
- In this chapter we studied how a business starts from scratch.
- The investors who invest in early stages of a business are called Angel investors.
- The funding provided by angel investors is called Series A Funding or Seed Funding.
- The investors who invest in the middle stages of a business are called Venture Capitalist.
- Appending provided by venture capitalist is called Series B funding.
- Venture Capitalist have some limitations that is they cannot invest more than a particular limit in a particular company.
- To overcome this limitation, the company raises funds from Private Equity investors who are professional investors and they generally invest when the company is already an established one and generating lot of revenues.
- An initial public offering (IPO) is the first time that the shares of a private company are offered to the general public at a particular price called Public Offer Price (POP).