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Initial Public Offering

In investing, there are two distinct markets - primary market and secondary market. Primary market is the place, where a security (stock) is created. Secondary market is the place where securities (stocks) are traded. A security is created in the primary market through a process known as Initial Public Offering (IPO). IPOs have been a very popular investment options both for retail and institutional investors since it has the potential of providing considerable capital appreciation for investors. Many IPOs over the last 10 - 15 years have given multi-bagger returns (i.e. more than 2 - 3 times) on listing.

What is IPO?

When a private limited company wants to raise funds to invest in the next stage of business growth, it has the option of taking their company public. In other words, the company will list itself on the stock exchange and invite subscription or investments from public e.g. institutional investors, HNIs and retail investors. The investors will in turn, become the shareholders of the company. Once listed, the shares of company will be traded in the stock exchanges. While the main purpose of an IPO is to fund the next stage of business growth, it also provides opportunity for some of the early stage investors (pre-listing) to exit their investments through the IPO.

How to invest in an IPO?

You need to have Demat and trading accounts to invest in IPOs. You can open a Demat and trading accounts with a stockbroker after fulfilling KYC requirements and providing the necessary documentation (e.g. identity proof, address proof, PAN, bank details etc). When a company announces its IPO, you can either subscribe to it online or filling out the subscription form and submitting it to your stockbroker. You need to provide your depository details and place your order (i.e. quantity, amount etc).

As mentioned earlier, you may not be allotted the number of shares subscribed; it will depend on the over-subscription / under-subscription. Please note that an under-subscribed IPO may be cancelled or postponed. However, the issuer may not always cancel or postpone an IPO just because it is under-subscribed. A very famous example of an under-subscribed IPO was Google in 2004; Google was forced to reduce the offer price. Yet today, Google or Alphabet has been one the biggest wealth creators for investors.

How does the IPO process work?

The IPO issuer usually approaches a merchant bank for the IPO for listing its shares on a stock exchange. The merchant bank acts as an intermediary between the seller and the investors. This step is also known as under-writing.

The merchant bank prepares the offer document, also known as the Draft Red Herring Prospectus (DRHP) and files it with SEBI for approval. The DRHP contains provides detailed information about the business operations and financials of the company. It includes details about its promoters, fund raising rationale, uses of funds and the risk factors involved, but it will not provide information about the offer price. As an investor, you should read the DRHP carefully before investing in the IPO.

Once SEBI approves the DRHP, the merchant bank goes to the Registrar of Companies (ROC) for approval of the IPO. Upon receiving the ROC approval, the merchant bank intimates the stock exchange (NSE, BSE or both) for listing, for which the stock exchanges have their own approval process.

While waiting for regulatory approvals, the issuer and their merchant bankers embark on road-shows, during which they promote the IPO with a select group of prospective investors and fund managers (mutual funds, FIIs etc). One of the purposes of the road-shows is to gauge investor interest, which can help the issuer / banker in pricing the IPO.

There are two pricing mechanisms of pricing an IPO - fixed price and book building. Shares of the company at inception are issued at a face value of Rs 10. At the time of the IPO the issuer decides on a premium over the face value. In a fixed price IPO, the issuer fixes a premium at which shares will be allotted. In a book building IPO, the issuer indicates a price band within which investors are allowed to bid. For example, in a fixed price IPO, the issuer may fix the premium at Rs 45 on a face value of Rs 10 per share. So the shares will be issued at Rs 55. In a book building IPO, the issuer may indicate a price range of Rs 50 - 60 and investors would bid within the range.

On the date mentioned in the DHRP, the shares are made available to the public for subscription. During the subscription window, the investors will fill out the application form and submit to their brokers.

Once the subscription window closes, the merchant banker and issuer fixes an offer price depending on the demand for the issue. If an issue is over-subscribed, i.e. demand for the IPO (from investors) is more than the supply (size of the issue in DRHP), then you may not get your desired allotment (you will be allotted lesser number of shares) or you may not be allotted any share.

On listing in stock exchanges, the allotted shares will be credited to the demat account of the subscribers. If you subscribed to an IPO and did not get any allotment, then your money will be refunded.

How to exit an IPO?

You can exit your investment in an IPO by selling your allotted shares on the listing day or holding your investments longer and selling it later. If you sell your IPO shares on listing days, you can make listing gains but there is no guarantee that you will get listing gains. You can also hold your shares for a long investment horizon, if you think that the company has good growth potential.