Initial Public Offering (IPO) refers to the process where private companies sell their shares to the public to raise equity capital from the public investors. The process of IPO transforms a privately-held company into a public company. This process also creates an opportunity for smart investors to earn a handsome return on their investments.
Investing in IPOs can be a smart move if you are an informed investor. But not every new IPO is a great opportunity. Benefits and risks go hand-in-hand. Before you join the bandwagon, it is important to understand the basics.
What is IPO in Stock Market?
IPO stands for Initial Public Offering. Initial Public Offering (IPO) can be defined as the process in which a private company or corporation can become public by selling a portion of its stake to the investors.
An IPO is generally initiated to infuse the new equity capital to the firm, to facilitate easy trading of the existing assets, to raise capital for the future or to monetize the investments made by existing stakeholders.
The institutional investors, high net worth individuals (HNIs) and the public can access the details of the first sale of shares in the prospectus. The prospectus is a lengthy document that lists the details of the proposed offerings.
Once the IPO is done, the shares of the firm are listed and can be traded freely in the open market. The stock exchange imposes a minimum free float on the shares both in absolute terms and as a ratio of the total share capital.
Types of IPO
1) Fixed Price Offering
Fixed Price IPO can be referred to as the issue price that some companies set for the initial sale of their shares. The investors come to know about the price of the stocks that the company decides to make public.
The demand for the stocks in the market can be known once the issue is closed. If the investors partake in this IPO, they must ensure that they pay the full price of the shares when making the application.
2) Book Building Offering
In the case of book building, the company initiating an IPO offers a 20% price band on the stocks to the investors. Interested investors bid on the shares before the final price is decided. Here, the investors need to specify the number of shares they intend to buy and the amount they are willing to pay per share.
The lowest share price is referred to as the floor price, and the highest stock price is known as the cap price. The ultimate decision regarding the price of the shares is determined by investors’ bids.
Benefits of Investing in an IPO
Increased Recognition
When weighing the advantages and cons of an IPO, this good factor comes out on top. It assists management in gaining more reputation and credibility by becoming a trustworthy organization.
Companies that are publicly traded are typically more well-known than their private competitors. In addition, a successful process attracts media attention in the financial sector.
Access to Capital
A corporation may never receive more capital than it raises by going public. A company’s growth trajectory might be substantially altered by the substantial cash available. An ambitious company may enter a new period of financial stability following its IPO.
This decision can help R&D, hire new employees, establish facilities, pay off debt, finance capital expenditures, and purchase new technologies, among other things.
Diversification Opportunity
When a corporation becomes public, its shares are traded on an exchange amongst investors. This increases investor diversity because no single investor owns a majority of the company’s outstanding stock. As a result, purchasing stock in a publicly listed company can help diversify investment portfolios.
Management Discipline
Going public encourages managers to prioritize profitability over other objectives, such as growth or expansion. It also makes contact with shareholders easier because they can’t hide their issues.
Third-Party Perspective
When a company goes public, it gains an independent perspective on its business model, marketing strategy, and other factors that could hinder it from becoming profitable.
Terms Associated with IPO
Terms | Descriptions |
Issuer | An issuer can be the company or the firm that wants to issue shares in the secondary market to finance its operations. |
Underwriter | An underwriter can be a banker, financial institution, merchant banker, or broker. It assists the company to underwrite their stocks. The underwriters also commit that they will subscribe to the balance shares if the stocks offered at IPO are not picked by the investors. |
Fixed Price IPO | Fixed Price IPO can be referred to as the issue price that some companies set for the initial sale of their shares. |
Price Band | A price band can be defined as a value-setting method where a seller offers an upper and lower cost limit, the range within which the interested buyers can place their bids. The range of the price band guides the buyers. |
Draft Red Herring Prospectus (DRHP) | The DRHP is the document that lets the public know about the company’s IPO listings after the approval made by SEBI. |
Under Subscription | Under Subscription takes place when the number of securities applied for is less than the number of shares made available to the public. |
Oversubscription | Oversubscription is when the number of shares offered to the public is less than the number of shares applied for. |
Green Shoe Option | It refers to an over-allotment option. It is an underwriting agreement that permits the underwriter to sell more shares than initially planned by the company. It happens when the demand for a share is seen higher than expected. |
Book Building | Book building is the process by which an underwriter or a merchant banker tries to determine the price at which the IPO will be offered. A book is made by the underwriter, where he submits the bids made by the institutional investors and fund managers for the number of shares and the price they are willing to pay. |
Flipping | Flipping is the practice of reselling an IPO stock in the first few days to earn a quick profit. |
FAQs
How does an IPO work?
An initial public offering (IPO) is the process through which a private company becomes public by selling its stock on a stock exchange. Private corporations engage with investment banks to introduce their shares to the public market, which necessitates extensive due diligence, marketing, and regulatory compliance.
Is IPO profitable?
They are an excellent way to invest your money because they provide enormous profits at a much lower risk than other possibilities. If the company does well, you can acquire relatively tiny stocks and significantly boost your profits.
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