A guide to Initial Public Offering (IPO):
India’s primary market has started on a high note this year, as a dozen companies have already raised more than Rs. 8000 crores through IPO till June 2016 and few more are expected to raise another Rs. 6000 crores in the next few months.
If you are a retail investor who wants to be a part of this IPO bandwagon, this article will help you understand the process of investing in an IPO.
So, What is an IPO?
Initial Public Offering i.e. IPO is a process through which an existing company with no shares listed on the stock exchange decides to go public by selling its shares to the general public. It’s in an IPO that a company offers its shares to the public for the first time.
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When a company is reaching to the public for the first time to raise money; it is referred to as IPO. On the other hand, if a company already listed on a stock exchange, and is issuing a fresh lot of shares, it is referred to as “new issue” or an FPO(Follow on Public Offer). The company issuing the shares is known as the “Issuer”.
IPOs are issued with the help of the investment banks. After the launch of IPO, company’s shares are traded on the open market and the shares can be further sold by the investors in the secondary market.
Methods of IPO Issue
Traditionally, there are two methods for IPO issue i.e. Fixed Price and Book Building.
• Fixed Price Method
In this method, the price at which the securities are to be offered and allotted is known in advance to the investors.
• Book Building Method
In this method, companies raise capital through IPO to encourage price and demand discovery. There is no fixed price per share; instead, the issuing company arrives at a price band. The lowest price is called as the “floor price” and the highest price is termed as the “cap price”. The bids are then collected from the investors at the prices within the range of the specified price band. Both institutional and retail investors participate in the bidding, and the final bid price is decided based on the demand generated by the issue, once the bid is closed.
Steps for Book Building process:
The issuer nominates the lead investment bankers as book runners or book running lead managers (BRLMs).
The issuer then decides the number of securities to be issued and the price band for the bids.
The issuer then nominates the syndicate members with whom investors place the order. The syndicate members after receiving the orders input them into an “electronic book”. Booking usually remains open for a minimum of 5 days.
Once the book building is closed, the bid is evaluated by the book runners based on the demand at different price levels and the issuer along with the book runner then decides the final price of the securities to be issued.
The shares are then allocated to the successful bidders and the remaining bidders get the refund orders.
Commonly used terminologies in the bidding process:
IPO Allotment Rule for Book Building Method:
There are three categories of investors who participate in IPO bidding process: Retail Individual Investors (RIIs), Qualified Institutional Investors (QIBs) and Non-Institutional Investors (NIIs) / High Networth Individuals (HNIs). Allocations to these categories are done in the ratio of 35:50:15 respectively. If there is a mandate for allocating 60% to QIBs as per the Rule 19(2)(b) of SCRR, then the portion allocated to RIIs and NIIs will be 30% and 10% respectively.
As per the new norm for allocation of shares by SEBI, all retail investors can invest in smaller lots of Rs. 10,000- 15,000. An applicant in RII category can apply for a maximum of Rs. 2 lakhs per IPO.
Important terms used in an IPO issue
• Draft Offer Document/ Draft Prospectus
It is a document containing the details of the company’s financials, its promoters, the reason behind company going public, how the pricing will be done, company’s background, etc. It is filed with SEBI by the lead managers. After SEBI’s clearance, the prospectus is filed with the Registrar of Companies (ROC) or the Stock Exchange. The final prospectus is available for print after the clearance from SEBI and ROC.
• Red Herring Prospectus
Red Herring Prospectus (RHP) is used in book building issues. It contains all the details about the company except the price details, the amount of issue or the number of shares being issued.
An underwriter could be an investment banker, a broker or any financial institution that enters into a contract with the issuer to distribute new securities to the public. Underwriters subscribe to the balance shares which are not picked up.
For instance, if there is an issue for Rs. 50 crores and the subscriptions are received for only Rs. 45 crores, then the remaining Rs. 5 crores shares have to be picked up by the underwriters.
• Lead Managers
Lead managers are responsible for the due diligence of the issue. They are also referred to as the merchant bankers or the investment bankers. Some of the functions of the lead managers are:
Act as a mediator between the issuer and the investors.
Responsible for complying with the regulations of the issue such as the format of the prospectus, marketing the issue.
Responsible for post issue activities like allotments and refunds. Investors may contact lead managers in case of non-receipt of shares/ funds.
• Green Shoe Option
The legal term used of the Green Shoe Option (GSO) in a company’s prospectus is known as “over-allotment option”. Issuer Company exercises the green shoe option to make sure that the share price does not fall below the issue price of the shares post IPO. It allows the companies to stabilise the share prices once they are listed. The stabilisation period is for 30 days.
GSO allows the underwriting syndicate to buy an additional share of up to 15% of the issued shares if the demand for the shares exceeds the expectations.
For example: If a company is planning to issue 1 lakh shares, then in agreement with the green shoe option company has to issue 1.15 lakh shares. Here, the over-allotment is 15,000 shares. These 15,000 shares are borrowed from the promoters.
• Qualified Institutional Buyers (QIBs)
Qualified Institutional Buyers (QIBs) are perceived to have the financial expertise to evaluate and invest in the capital market.
• Anchor Investors
Anchor Investors are the Qualified Institutional Buyers (QIBs). They invest in an IPO before the offer opens to the public and are the first investors in an IPO. Their role is to attract investors to the public issue, and gain public confidence before it is infused in the market. The value and volume subscribed by the anchor investors in the issue serve as an indicator of the company’s soundness and reputation of the offer.
They make an application for a value of Rs. 10 crores or more in a public issue made through the book building process. Allocation to the anchor investors is subject to a minimum of 2 such investors for an allocation of up to Rs. 250 crores and 5 such investors for an allocation of more than Rs. 250 crores.
• Applications Supported by Blocked Amount (ASBA)
It is an application developed by the India’s Stock Market Regulator SEBI for subscribing to an IPO. Under this facility, applicant’s account doesn’t get debited until the shares are allotted to them.
Investors can apply for any public/ rights issue using their bank account. An investor can submit the ASBA form (available at the designated bank branches acting as SCSB) after filling their details to their banking branches. ASBA forms are accessible on the NSE website.
Self Certified Syndicate Banks (SCSB) recognised by SEBI is capable of providing ASBA services to the customers. SCSBs accepts the applications and verifies it, block the fund to the extent of bid payment amount, upload the details in the web-based bidding system of NSE, unblock once the basis of allotment is finalised and then transfer the amount for allotted shares to the issuer. List of SCSBs is available on the SEBI as well as NSE website.
Also read: Here is how to apply for an IPO through ASBA
It’s easy to know about a company which is already listed on the stock exchange, as a lot of information about the company will be available from its annual reports, reports from brokerage houses, media articles, etc.
However, in the case of an IPO, the dependency is on the Red Herring Prospectus (RHP) issued by the company. You will not have the information on the corporate governance observed by the company, credibility of the management regarding the guidance it gives, the trustworthiness of the information shared, etc.
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For the evaluation of an IPO, it’s important that you read the prospectus carefully and go through all the details disclosed by the company. The prospectus will help you to know about the management, their track record and vision. Comparing the new company with its peers in the market will help you understand its financial robustness. Investment bankers and promoters sometimes quote the higher price, in such a scenario you can buy the stock at a later stage when the price corrects.
Under the “risk factor” section of the prospectus, you can find out whether any legal cases are going on against the company. In such a scenario, it’s prudent to stay away.
Another point that one can consider for evaluation is by looking at the level of the institutional bidding. If the institutional investors are taking an interest in the company, it’s an indication of the company and the price validation by them, which is a positive sign to choose the company.
If the private equity investors are leaving the IPO, it’s an implication that they don’t see an exciting future growth of the company and investing in such a company is not a good bet.
Great post on IPO . It’s very well written explaining concepts in simple terms. This was very helpful . Thanks for sharing.