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What Is An IPO And Why Invest In It? Research Team | Posted On Monday, October 07,2013, 05:59 PM

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What Is An IPO  And Why Invest In It?



One must have heard of a popular saying” No Capital No Business”. No matter how great a business model a company might have all effort comes to nought without sound working capital .Capital is the lifeblood of the Company .In order to raise capital in the primary market a business launches an initial public offer popularly called an IPO.

What Is An IPO?

The first time a Company sells its stock to the public is known as an initial public offer. These are mainly launched by Companies which are new but have a very sound business model and see vast scope for expansion in their business. An IPO could also be launched by a Company which has been in business for a while but wants to raise additional capital by selling part of its ownership to the public.

The Company launches an IPO which is called “Going Public” and raises capital by selling the stake in the Company to the public. The Company which is going public then files a draft offer document with the Securities and Exchange Board of India popularly known as SEBI. The IPO prospectus is validated to check if all information in the offer document is true and enough information is provided to the investors to make an informed decision.

  • A Company must have net tangible assets of at least 3 Crores in each of its preceding three full year’s
  • Distributable profits in at least three out of the preceding five years.
  • A net worth of at least a crore in each of the preceding three years.
  • The issue size should not exceed five times the pre issue net worth.
  • If there is a change in the name of the Company at least 50% of the revenue for the preceding one year should be from the new activity denoted by the new name.

The validity period of SEBI observations is only for three months .The issue needs to be opened within this three month period.

What is the Book Building Process?

The main step involved in the launch of an IPO is the fixing of its price .The process of discovering the price of an IPO is known as book building. In the pricing process the investors themselves get to decide the optimum price of the issue which is also acceptable to the Company through a very interesting and an interactive process known as book building.

The shares do not have a predetermined price but instead a price range or a price band is provided. The company fixes the price band which sets up the minimum and maximum price limit known as the floor price and the cap price.

The floor price is the minimum price the investor can bid for the share and the cap price is the maximum price the investor may bid for it. The investors then offer bids for the shares. The investors state what quantity of shares and at what price they are willing to purchase these shares within the price band. The bid is then closed. The issue price or the price the securities can be sold is then decided based on the bids made. The successful bidders are allocated shares and the price at which the shares are allocated is known as the cut off price.

What is a Qualified Institutional Buyer?

Qualified institutional buyers popularly known as QIB’s are mainly investors who possess good financial muscle and knowledge. They may be mutual funds, foreign institutional investors, banks or pension funds. At least 50% of the size of the issue needs to be subscribed to by the QIB’s.

What is an Anchor Investor?

Anchor investors are a part of the qualified institutional buyers (QIB) and aid the price discovery process .Before the book building process is launched the floor price and the cap price need to be determined. The QIB’s and the anchor investors help to fix these prices.

If the anchor investors are bullish on the IPO then a higher cap price is fixed up to a certain maximum limit. In any field especially business big names and big reputations serve as a boost to investments .In the same way anchor investors serve as an anchor or a support to the IPO.

Anchor investors having big names add to the reputation of the IPO and boost investor confidence. Retail investors perceive that if anchor investors of great knowledge and repute invest in the IPO then it must be good They serve as brand ambassadors to the IPO. According to SEBI rules and guidelines anchor investors need to stay invested for a period of at least 30 days.

This protects retail investors from a sharp fall in prices due to excessive selling by the anchor investors. A minimum subscription of at least 50% is taken up by QIB and anchor investors subscribe to at least 30% of it. The anchor investors by staying invested for a minimum of 30 days and subscribing for 30% of the issue size lend stability to the IPO.

Once the issue price is fixed and the price offered by the anchor investor is lower they need to pay up the difference. If the price paid by the anchor investor is higher than the issue price they lose out on the difference amount. This encourages anchor investors to do their homework or research properly before investing in the IPO.

How Does the IPO Work?

  • The issuing Company appoints a merchant banker also called an investment bank in the role of an underwriter. The underwriter is responsible for pricing, selling and the organization of the issue and serves as a bridge between the investing public and the Company.
  • They make sure that the Company obtains all regulatory clearances ,filing with SEBI is done on time ,all applicable fees are paid and all appropriate financial data is made available to the investing public.
  • The underwriter is the risk manager of the firm and also recommends an IPO price to the firm. Underwriters charge a fee for their services which is a percentage of the issue size .If the issue size is too large a syndicate of merchant bankers might be appointed to underwrite the issue.
  • The issuing Company decides the number of securities to be issued and the price band.
  • The issuing Company nominates associate members with whom investors can place their orders.
  • Investors place their orders with associate members and the orders are keyed in an electronic format through a process known as bidding.
  • The period a book stays open is up to 5 days and bids out of the price band are not accepted.
  • On the completion of the book building process the bids are assessed. Allocation of shares is made to successful bidders.
  • According to the SEBI mandate the bidding period is a minimum of 3 days and a maximum of 10 days. The time gap between the closure of the issue and the final listing has been reduced from 12 days to 5 days.

Why Invest In An IPO?

  • The IPO follows a process of price discovery known as book building .This helps to fix prices which would be friendlier towards retail investors .It is easy to arrive at a realistic price through a book building process.
  • The minimum application size has been increased from INR 8000-10000 to INR 12000-15000.
  • Earlier in case of oversubscription only those with the highest bids were allocated shares proportionately. In case a retail investor applied for shares worth a lakh at the upper end of the price band and the issue got subscribed 10 times one would get shares of worth INR 10000.(Value of shares applied for / Size of the issue oversubscribed).Retail investors who bid for lesser amounts were not allocated any shares. According to the new rules every retail investor gets a certain minimum number of shares subject to availability while the remaining will be allotted proportionately. This encourages retail investors who are fence sitters to participate in the IPO.
  • In case of HNI who would otherwise get shares in larger proportions and are denied because of the new rules can open basic demat accounts in the names of their family members and newer investors are lured into the IPO.
  • Another major rule which has been passed does not allow QIB’s and anchor investors to withdraw the investments for a period of 30 days. Non retail investors are not allowed to withdraw bids. Earlier HNI would invest in the IPO and seeing these reputed investors retail investors would invest in bulk. This led to a huge oversubscription. The HNI’s making use of these good valuations would withdraw their bids resulting in severe losses to retail investors.
  • To encourage liquidity rules have been passed that in Companies at least 25% needs to be public float. This encourages greater participation of retail investors in the IPO.
  • Corporates will need to have a minimum average pre-tax operating profit of INR 15 Crores in three of the five preceding years and if they fail to meet this criteria QIB participation needs to be hiked to 75% from the existing 50%or they would have to list on the small and medium industries platform known as SME Platform.

I would like to end this article by stating that investing in an IPO involves considerable research and strategy. Most of the IPO launches are in a bullish market environment and one needs to be careful before jumping unto the IPO bandwagon. Just as all financial instruments have their advantages and disadvantages so do IPO’s .If the IPO matches ones set goals and objectives then one must march ahead and invest without fear.

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