IPOs
Basics of stock market
• Why invest?
• who regulates
• financial interdependence
• IPOs
• Stock Market returns
• Trading system
• Day end settlements
• Corporate actions
• News and Events
• Getting started
• Rights, ofs,fpo and more
• Notes
4.1 Overview
Firstly, The first three chapters have provided background information on some of the fundamental market ideas you should understand. At this point, answering the fundamental question of why companies go public becomes crucial.
Secondly, A thorough understanding of this subject lays the groundwork for all subsequent subjects. Throughout this chapter, new financial ideas will be introduced to us.
4.2 Origin of a Business
Definitely, Let’s spend some time understanding a more fundamental idea first: the beginnings of a typical business before moving on to try to find an explanation for why companies go public. Especially we will create a concrete story around this idea in order to better comprehend it. For a better understanding of how the business and the funding environment develop, let’s divide this story into several scenes.
Scene 1 – The Angels
firstly we try to find an explanation for why companies go public, let’s first spend some time understanding a more fundamental concept: the beginnings of a typical business. To better understand this concept, we will particularly build a concrete story around it. Let’s break this story down into different scenes to better understand how the business and the funding environment develop.
He would likely face the typical problem faced by entrepreneurs: where would he get the money to finance the idea? If the entrepreneur has no prior business experience, he won’t initially be able to draw in any serious investors. Most likely, he would solicit support for the idea from his loved ones and close friends. Also could have asked the bank for a loan, but that wasn’t the best course of action.
For Example 4.1
Assume he gathers his own funds and convinces two of his close friends to contribute to his business. These two friends are placing a blind wager on the entrepreneur importantly known as the Angel investors and investing in the pre-revenue stage. Please be aware that the money provided by the angels is an investment rather than a loan.
Whereas, let’s imagine that the promoter and the angel investors raise INR 5 Crore in the capital. The “Seed Fund” is the name given to the initial funding someone receives to start his business. It is significant to note that the seed money will reside in the business’ bank account rather than the promoter’s (also known as the entrepreneur’s) personal account. Once the seed money has been transferred into the business’s bank account, the monies are referred to as the original share capital of the company.
For Example 4.1.1
Moreover, The promoter and the two angel investors will receive share certificates that entitle them to the company in exchange for their initial seed investment.
Furthermore, The original three (the promoter and two angels) will receive share certificates from the company as payment for their initial seed investment, entitling them to ownership of the business.
Especially, The process of issuing shares is quite straightforward. The company assumes that each share is worth Rs. 10, and since there must be 50 lakh shares with an Rs. 5 crore share capital, each share must be worth Rs. 10. In this context, The share’s “Face Value” is 10 dollars (FV). Certainly, Any number could be the face value. The number of shares would be 1 crore if the FV was Rs. 5, and so on.
Surely, The authorized shares of the company are 50 lakh in number. The Promoter, two Angel Investors, and the Company shall each get a portion of the Shares and the Company shall retain the balance of the Shares for future issuance.
Assume, for the time being, that the promoter keeps 40% of the shares, the two angel investors receive 5% each, and the firm keeps 50% of the shares. This portion is referred to as “issued shares” because the promoter and two angel investors own 50% of the shares.
| 1 | Promoter | 20,00,000 | 40% |
| 2 | Angel 1 | 2,50,000 | 5% |
| 3 | Angel 2 | 2,50,000 | 5% |
| Total | 25,00,000 | 50% | |
It should be emphasized that the firm owns 2,500,000 equity shares or the remaining 50% of the shares. Despite being authorized, these shares have not yet been distributed.
Without a doubt, The promoter now launches his company operations with the support of a solid corporate structure and a sizable seed fund. He wants to proceed with caution. Therefore, he decides to only open one store to sell his product and one small manufacturing facility.
Scene 2 – The Venture Capitalist
His perseverance pays off, and business begins to increase. The business begins to break even after its first two years of operation. The promoter is no longer a start-up company owner. Instead, he has more in-depth knowledge of his own company and, obviously, more confidence.
Without a doubt, of his confidence, the promoter now wants to grow his company by opening a few more retail stores and one more manufacturing unit in the city. Never, He develops the strategy and decides that a new investment of INR 7 Cr is necessary for the growth of his business.
Also, Comparing where he is now to where he was two years ago, he is in a better place. The main distinction is that his company is bringing in money. The consistent influx of income validates the company and its goods. He is now in a position where he can access investors who are reasonably well-informed about his industry. Let’s assume he runs into one such experienced investor who is willing to give him 7 Cr. in exchange for a 14.4% stake in his business.
. Series A funding is the name of the finance the company receives at this point, and a venture capitalist is a person who often invests in a company at this early stage (VC).
After the company agrees to allot 14% to the VC from the authorized capital, the shareholding pattern looks like this:
| Sl No | Name of Share Holder | No of Shares | %Holding |
| 1 | Promoter | 20,00,000 | 40% |
| 2 | Angel 1 | 2,50,000 | 5% |
| 3 | Venture Capitalist | 7,00,000 | 14% |
| 4 | Angel 2 | 2,50,000 | 5% |
| Total | 32,00,000 | 64% | |
Notably, the remaining 36% of the shares, which have not been allocated, are still owned by the company.
With the VC’s money coming into the business, an exciting development has taken place. The VC values the entire business at INR 50 Crs by valuing his 14% stake in the company at INR 7Crs. With the initial valuation of 5Crs, there is a 10-fold increase in the company’s valuation. This is what a good business plan, validated by a healthy revenue stream, can do to businesses. It works as a perfect recipe for wealth creation.
Scene 3 – The Banker
Apart from this after three more years, the business achieves incredible success. The business decides to open stores in at least three more cities. The company also intends to boost its production capacity and hire more personnel to support the retail presence it has established in three cities. The term “Capital Expenditure” or simply “CAPEX” refers to any expenditure a company plans to make to enhance its overall operations.
The management predicts 40Crs in CAPEX expenditures. How does the business obtain this funding, or how does it manage to meet its CAPEX needs?
The corporation has few choices for raising the money needed for their CAPEX:
- The company’s recent profits, which have enabled it to turn a profit, can be used to cover a portion of the CAPEX requirement.
- By allocating shares from the authorized capital, the company can approach a different venture capitalist (VC) and raise Series B funding.
- The business may approach a bank to ask for a loan. The company has been doing reasonably well, so the bank would be happy to offer this loan. Another name for the loan is “Debt.”
To raise money for Capex, the company decides to use all three of its available options. It invests 15 crores from internal accruals, plans a series B, sells 5 crores of equity to another VC for 10 crores, and obtains 15 crores of debt from the banker.
Note, with 10Crs coming in for 5%, the company’s valuation now stands at 200 Crs. Of course, this may seem a bit exaggerated, but then the whole purpose of this story is to drive across the concept!
Scene 4 – The Private Equity
A few years go by, and the business’ success is still evident. The ambitions of this eight-year-old, $200 million company are rising along with its success. The business makes the decision to raise the bar and expand across the nation. Additionally, they choose to diversify the business by producing and selling designer cosmetics, perfumes, and fashion accessories.
The CAPEX budget for the new target is presently 60 Cr. Because the finance charges, also known as interest rates, would reduce the company’s profits, the company does not want to raise money through debt.
From the authorized capital, they choose to distribute shares for a Series C funding. Since typical VC funding is typically modest and only amounts to a few crores, they are unable to approach one. A private equity (PE) investor enters the picture at this point.
PE investors are very intelligent. They are extremely skilled and come from a strong professional background. They put their own people on the board of the investee company to make sure the business is steering in the right directions and invest sizable sums of money to provide the capital for useful use.
Scene 5 – The IPO
Not only but also after the PE investment, the company has made great progress five years later. They have a presence in all of the major cities across the nation and have successfully diversified its product line. Revenues and profitability are both robust, and the investors are happy. The promoter, however, is not content to stop there.
The promoter now has international ambitions! He wants at least two outlets in every significant city around the world, ensuring that his brand is present in all major international cities.
This means the business must spend money on market research to learn what other people want, invest in its workforce, and expand its manufacturing capabilities. In addition, they also need to invest in the global real estate space.
This time, there is a significant CAPEX requirement that the management anticipates will cost $200 Cr. The company’s options for funding the necessary CAPEX are limited.
- From internal accruals, finance Capex
- Raise Series D through a different PE fund.
- borrow more money from banks
- Bond flotation (this is another form of raising debt)
- Publish an Initial Public Offering (IPO) by distributing shares from the authorized capital.
For convenience, let us assume the company decides to fund the CAPEX partly through internal accruals and files for an IPO. When a company files for an IPO, they have to offer its shares to the general public. The general public will subscribe to the shares (i.e. if they want to) by paying a certain price. Due to the fact that the corporation is presenting the shares to the public for the first time, it is now known as the “Initial Public Offer.”
4.3 Overview of The IPO Markets
In the last topic, we learnt how a company develops from the point at which ideas are conceived to the point at which it decides to file for an IPO. The hypothetical scenario in the previous chapter was designed to give you an idea of how a business evolves through time. Clearly, the focus was on the various business stages and the funding options available at each stage. You can see what a company would have gone through before going public and offering its shares in the previous chapter.
This is crucial information to understand because the primary market, also known as the IPO market, occasionally attracts businesses that offer their shares to the public without actually having gone through a robust round of funding in the past. Credible VC and PE firms have validated the quality of the company and its promoters through a few rounds of funding. Although you should take this with a grain of salt, it nonetheless serves as a sign of well-run businesses.
4.4 What drives a company's IPO?
We came to some important conclusions in the previous chapter. One of which is: Why did the business choose to file for an IPO, and generally speaking, why do businesses go public?
Firstly primary motivation for a company to file for an IPO is almost always to raise money to support their CAPEX requirement. Third benefits flow to the promoter from making his business public:
- He is raising funds to meet CAPEX requirement
- By avoiding the need to raise debt, he will avoid finance charges, which will increase his profitability.
- You essentially assume the same level of risk when you purchase stock in a company as the promoter does. It goes without saying that the risk’s percentage and its effect will depend on how many shares you own.
- Nevertheless, whether you like it or not, purchasing shares involves taking on risk. Secondly promoter is actually distributing his risk among a large number of people when the company goes public.
There are other advantages as well in going for an IPO
- Reward employees- As a reward for their work, the company would assign shares to its employees. The term “Employee Stock Option” refers to this type of agreement between the company and the employee. The employees receive the shares at a reduced price. When the business goes public, the staff members may benefit from share price growth. Google, Infosys, Twitter, Facebook, and other companies are a few instances where employees have benefited from ESOPs.
- Provide an exit for early investors – Once the company goes public, the shares of the company start trading publicly. Any existing shareholder of the company – could be promoters, angel investors, venture capitalists, or PE funds; can use this opportunity to sell their shares in the open market. By selling their shares, they get an exit on their initial investment in the company. They can also choose to sell their shares in smaller chunks if they wish.
- Increased visibility – The company’s visibility is unquestionably increased by the status of being publicly held and traded that comes with becoming public.
4.5 – Merchant Bankers
Firstly the business must now take a number of actions to ensure a successful initial public offering after deciding to go public. Choosing a merchant banker would be the first and most important step. whereas other names for merchant bankers include Book Running Lead Managers (BRLM) and Lead Manager (LM). A merchant banker’s responsibility is to help the company with various IPO-related tasks, such as:
- Conduct due diligence on the company filing for an IPO, ensure their legal compliance and also issue a due diligence certificate
- should closely collaborate with the business to create their listing materials, such as a draught Red Herring Prospectus (DRHP). Later on, we will go into more detail about this.
- Underwrite shares – When a merchant banker underwrites shares, they essentially agree to purchase all or a portion of the IPO shares and resell them to the general public.
- assist the company in determining the IPO price range. A price band is a range between which a company will list its shares on the stock exchange. In our example, the price range will be between Rs. 1661 and Rs. 1871.-
- Assist the company with its roadshows – For example, a marketing or advertising campaign for the company’s IPO
4.6 Sequence of events during an IPO
It should be noted to say, each and every step involved in the IPO sequence has to happen under the SEBI guidelines. In general, the following are the sequence of steps involved.
Appoint a merchant banker. In case of a large public issue, the company can appoint more than 1 merchant banker
Apply to SEBI with a registration statement – The registration statement contains details on what the company does, why the company plans to go public and the financial health of the company
Getting a nod from SEBI – Once SEBI receives the registration statement, SEBI takes a call on whether to issue a go-ahead or a ‘no go’ to the IPO
DRHP – If the company gets the initial SEBI nod, then the company needs to prepare the DRHP. A DRHP is a document that gets circulated to the public. The following information should be included in DRHP along with a lot of other information:
- Size of the planned IPO
- The projected number of shares that will be made public.
- It is stated clearly that the company wants to go public, what it intends to do with the proceeds, and when it anticipates using them.
- Description of the business, including the revenue model and financial information
- Discussion and analysis of management: how the company anticipates future business operations to develop
4.7 What happens after the IPO?
Investors may offer to purchase shares during the bidding process (also known as the date of issue) within the predetermined price range. The Primary Market is the term used to describe the entire system where buyers and sellers compete for shares around the issue date. Public trading of the stock starts as soon as it is listed and makes its debut on the stock exchange. The term “secondary market” refers to this.
Once the stock transitions from primary markets to secondary markets, it is traded every day on the stock exchange. People begin regularly buying and selling stocks.
As to why people trade, Why does the price of the stock change? Well, in the following chapters, we’ll address all of these inquiries and more.
4.8 Few key IPO jargons
Under subscription – Let’s say the company wants to sell 100,000 shares to the general public under subscription. The issue is considered under-subscribed when it is revealed throughout the book-building process that only 90,000 bids were received. This situation is not ideal because it reflects unfavorable attitudes among the general public.- Oversubscription – If 200,000 bids are received for every 100,000 shares offered, the issue is considered to be two times oversubscribed (2x)
- In the case of an oversubscription, the Green Shoe Option provision in the underwriting agreement allows the issuer to distribute additional shares, often 15% more. The overallotment option is another name for this.
- Price Band and Cut off price – The price band is a price range between which the stock gets listed. For example, if the price band is between Rs.100 and Rs.130, then the issue can list within the range. If it is advertised at $125, that amount is referred to as the cutoff price.
4.9 – Recent IPO’s in India*
