A Complete Guide for Beginners on How to Invest in IPOs

What is an IPO?

An IPO stands for initial public offering.

The IPO process is where an unlisted company sells new or existing securities by offering them to the public for the first time.

It's the very first sale of a stock issued by a company on the stock market.

This turns a private company into a public company by selling a portion of its stake to investors.

After an IPO, the issuing company becomes a publicly listed company on a recognised stock exchange. Thus, an IPO is also commonly known as 'going public'.

Once the process is done, the shares of the firm are listed and is traded freely in the open market.

When the company gets listed, its business is owned by a large number of people i.e. shareholders.

In effect, the company goes from being owned by just a few people to potentially tens of thousands of shareholders.

Why does a company decide to go public?

There are many reasons behind a company's decision to go public. Here are some advantages that a private company can derive by launching an IPO.

Raising capital

Raising capital helps the company grow, innovate, expand and take risks because IPOs can provide them with a financial cushion.

Initially, a private company supports its operations through private funds.

As the company grows, it can reach a stage where it needs a huge infusion of capital to expand, scale-up operations, pay debt or various other reasons.

If the owners of the company wish to raise capital to finance future growth or to pay off debt, they have to ask existing shareholders.

They may be unwilling or unable to provide more money. So the company needs to look at other options.

While banks are an obvious choice, there can be a limit to the amount of funds they can offer based on their analysis of the company.

Also, high interest rates can hurt the company's finances.

The other option is going public.

Since market regulator mandates all companies to disclose their complete financial information before launching an IPO, investors can analyse their performance before investing in them.

Liquidity

By going public, a company provides liquidity for its shareholders.

When a company grows, its major shareholders may wish to cash in on the wealth they have tied up in the business.

The public offer creates a market for the company's shares that gives investors the ability to sell their holdings.

Enhances the credibility

The capital markets regulator of India has laid down some stringent norms to allow companies to go public.

If a company is listed on a stock exchange, people can be assured of a few things like the transparency of financial data since the regulator asks all companies to report it periodically, better management, etc.

Once a company goes public, its credibility usually improves.

Valuation

Going public sets a market value for company's shares.

Hence, it provides an insight into the company's market worth.

A company that has a good market worth can attract good talent and better options for acquisitions or mergers.

Diversification

Another use of the IPO money is to invest in similar businesses, which can make the core business stronger.

Using the IPO money for diversification is a common strategy for many companies.

Organic growth

A possibility for companies is to expand the business organically.

Companies do this by hiring more engineers, opening more offices around the world, and ramping up its infrastructure.

This expands their network organically and also helps restless investors to see some of the money put towards tangible resources.

Boosts market visibility

When a company launches an IPO, it garners attention from the public.

People who have never heard about the company but invest in the stock markets start researching it and assessing its financials.

This helps it gaining market exposure.

How does an IPO work?

Going public is a challenging, time-consuming process.

A private company planning an IPO needs to prepare itself for an exponential increase in public scrutiny.

It also has to file a ton of paperwork and financial disclosures to meet the requirements of the market regulator, which oversees public companies.

The paperwork and financial disclosures filed with the Indian stock market regulator is also called as draft red herring prospectus (DRHP).

That's why a private company that plans to go public hires an underwriter, usually an investment bank, to consult on the IPO and help it set an initial price for the offering.

Underwriters help management prepare for an IPO by creating key documents for investors and scheduling meetings with them.

An underwriter can be a bank, financial institution, merchant bank or a broker.

Once the company and its advisors have set an initial price for the IPO, the underwriter issues shares to investors and the company's stock begins trading on a public stock exchanges.

Why is the Draft Red Herring Prospectus important?

Many companies have lined up to come out with their IPOs recently.

In order to understand a firm fully, one of the most important tools is the DRHP.

A DRHP provides detailed information about the company's business operations and financials.

This includes details about its promoters, purpose of raising funds, how the money will be used, risks involved, balance sheet, earnings statement, stockholder who possess 10% or more than the currently outstanding stock, copy of the underwriting document and so on.

Criteria for filing IPOs

The following are the eligibility norms for companies planning to file an IPO.

• The company should have had net tangible assets (defined as physical assets plus monetary assets) of at least Rs 30 m in each of the last three years. This doesn't include virtual assets with fluctuating value like shares.
• The company should have had a minimum operating profit of Rs 150 m for at least three years in the preceding five years.
• The size of the IPO can't exceed the company's worth by more than five times.

Even if these criteria are not fulfilled, the company can still file a request for approval of an IPO with the watchdog.

But for such approvals, the IPO can only take the book building route where 75% of the stock has to be sold to qualified institutional investors (QII).

This has to be done for the sale of stocks under the IPO to be held as valid. Otherwise, the IPO is cancelled and the capital raised has to be returned.

The stock market regulator functions to protect the interests of investors while ensuring that norms aren't too stringent to dissuade prospective companies from listing.

Key terms associated with IPO

Issue price: The price at which shares of the company will be sold to investors before the company begins trading on stock exchanges.

It is also referred to as the offering price.

Lot size: It is the minimum number of shares, an investor can bid in an IPO.

If someone wants to bid for more shares, it has to be in multiples of the lots size.

For example, if the lot size for an IPO is 1,500 shares, that person has to bid for at least these many.

If he/she wants to bid for more, it will be in multiples of 1,500, such as 3,000 and 4,500.

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.

Book building: The process by which an underwriter or a merchant banker tries to determine the price at which the IPO will be offered is called book building.

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.

Once an idea has been made and the price band is decided, the underwriter decides the IPO price.

Under subscription

Undersubscribed is a situation in which the demand for an IPO is less than the number of shares issued.

Over subscription

Oversubscribed is a term used for when the demand for a new issue of securities is greater than the number of securities offered.

When a new issue is oversubscribed, underwriters or other financial entities offering the security can adjust the price upward or offer more securities to reflect the higher-than-anticipated demand.

Green shoe option

It refers to an overallotment option.

It is an underwriting agreement that permits the underwriter to sell more shares than initially planned by the company.

It happens in cases when the demand for a share is seen higher than expected.

Basically, it lets the issuer company release additional shares in the secondary market in the event of oversubscription.

What is grey market in IPO?

Grey market is an unofficial market where individuals buy and sell IPO shares before they are officially launched for trading on the stock exchange.

As it is an unofficial over the counter market, there are no regulations around it. All transactions are done in cash on a personal basis.

Third party companies like market regulator, stock exchange or brokers are not involved in this transaction.

Two popular terms used in the IPO grey market are 'Grey Market Premium' and 'Kostak'.

What is grey market premium?

Grey market premium (GMP) is a premium amount at which grey market IPO shares are traded before they get listed in the stock exchange.

In simple words, the stock of the company that came up with the IPO bought and sold outside the stock market.

The GPM reflects how the IPO might react on a listing day.

For instance, if the company introduces an IPO for Rs 100 per share and the grey market premium is around Rs 20 then we can assume the IPO to list around Rs 120 per share on listing day.

There is no reliability but in most cases, the GMP works properly and the IPO lists around the given price.

What are Kostak rates?

In the IPO grey market, the Kostak rate is the amount paid for an IPO application before the shares get listed in the stock market.

One of the ways people sell their shares in grey market is by selling the complete IPO application to the buyer.

For example, an investor applied shares of Rs 2 lakh in XYZ company's IPO. He/she is not sure how many shares will get allocated and what listing gains could be.

On the other side, there is another buyer who is ready to take the risk. They will say, 'Sell me your Rs 2 lakh IPO application at Rs 5,000.'

If the seller agrees, he/she could get Rs 5,000 and exit from this transaction.

Rs 5,000 is the Kostak.

In almost all cases, the buyer asks the seller to sell the shares on the listing day and settle the difference.

Note that tax liability remains with the application seller. This could eat up profits if the difference is very high.

Suppose you are a seller. If the profit you made on the listing day is Rs 30,000, then you will have to pay Rs 25,000 (Rs 30,000 - Rs 5,000) to the buyer.

You are liable to pay taxes on Rs 30,000 which at the rate of 20% could be Rs 6,000. This could result into net loss of Rs 1,000 in this transaction.

To Sum Up

Whether or not to invest in an initial public offering is a choice of an investor, but it is one way to accentuate the earning potential of one's investment.

IPOs are often considered to be big events in the stock market for a reason.

By investing in the right company, investors stand a chance to earn good returns in the long run.

But the trick is to identify the good performers from the rest.

List of upcoming IPOs

Company name	Sector	Issue size
Paytm	Miscellaneous	Rs 220 bn
Zomato	Miscellaneous	Rs 82.5 bn
Shyam Metalics	Steel	Rs 11.1 bn
Adani Wilmar	Food & tobacco	Not Available
GoAir	Airlines	Not Available
Life Insurance Corporation (LIC)	Insurance	Not Available

Source: Equitymaster

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Happy Investing!