IPO Basics : What is IPO, IPO Investment, Red Herring Prospectus & More

Definition of IPO

IPO or Initial Public Offering is the first opportunity for the public at large to invest in a company. Among the first questions, a new investor grapples with is what is an IPO and should one look to invest in them at all.

During the dot com bubble, many investors doubled their investments just by flipping stocks, that is investing in an IPO and sell to make huge first-day gains. But as the bubble burst and many of these companies disappointed the long-term investors, IPOs lost their charm for the casual investor. The article is divided into 4 major sections highlighted below and demystifies the basics of an IPO.

What is IPO

What is an IPO?

The very first time a company offers its stock for sale to the public is called an IPO. Before an IPO, a company is considered private with investors typically limited to the founders, their families & friends, and professional investors like Venture Capitalists and Angel Investors. While individual investors who were not involved in the early stages of the company can approach the owners of a private company to make an investment – they are not obliged to sell. On the other hand, with an IPO a company “goes public” and at least a portion of its shares becomes available for trade on stock-exchanges.

By going public, a company some of the benefits private enterprises have. For example, a private company need not disclose most of its financial and accounting information. But a public company will have to disclose the same to be compliant with SEBI guidelines.

This also adds on to the legal and accounting costs of the company. Significant management time will also be spent on creating further, the principal-agent problem is exaggerated and founders lose some of their control as new shareholders obtain voting rights. A public company faces a greater legal and regulatory risk as well, increasing the time and effort needed for reporting and compliance.

Why have an IPO?

why do companies go public at all? The primary reason is that the cost of capital for the company goes down drastically. While a private company can raise funds through borrowing or approaching other private investors, the amounts that can be raised through a stock exchange are typically much higher. Further, the increased scrutiny and stronger regulations translate into improved credit rating and lower interest rates on any debts the company may issue.

When the shares of a company are traded publicly, the liquidity increases for the investors. Valuation of the investments becomes easier as the price discovery of the stock happens readily and a pool of buyers is available. The increased liquidity also makes Employee Stock Options (ESOP) an attractive benefit for the top talent available to the company.

Early investors and founders look at the IPO as their key exit strategy. They would like to sell at least some of the shares they hold and reap rewards for the risk they took when investing in a new venture.

Investing in an IPO

As an IPO is the primary exit strategy for the early investors, a company decides to go for it only after careful analysis to determine that they can indeed raise the highest possible capital through it. Therefore, an initial public offering is made at a time when the future prospects for the engagement are bright and many public investors will be interested in participating in future growth. Investors who receive the stock through an IPO get it at the IPO price which is typically lower than the market price it will start trading at. An IPO is said to be oversubscribed when more people demand shares than the number of share on offer. Getting a piece of an oversubscribed share is difficult for individual investors. One needs to look at the process of underwriting to understand why.

Underwriting is the process by which a company gets ready to raise capital via either debt or equity sale. When a company decides to go for an IPO, they approach an investment bank to function as an underwriter. Before the underwriting process can begin, the company must ensure that they have a professional management team in place to steer the company post going public. It also needs to obtain audited financial statements compliant with generally accepted accounting principles, establish anti-takeover defences such as poison pills, and put in place a corporate governance strategy with an independent board of directors and qualified officers. Further, it is imperative that the company takes advantage of market sentiments and avoids going public during an economic downturn. The company should be compliant with the regulations arising from Securities Contracts (Regulations) Act 1956, Companies Act 1956, Securities and Exchange Board of India Act 1992, and any other regulations framed under these statutes as well as any circular, clarifications, guidelines issued by the appropriate authority under the same.

Once the required criteria are met, the owners meet with an investment bank to finalize details like the amount to be raised, the type of securities to be offered and the structure of the deal. In a firm commitment, the company guarantees that a certain minimum amount would be raised and buys the shares for that amount and tries to sell them via trading. On the other hand, in a best-effort agreement the underwriter sells the securities for the company but does not guarantee any amount to be raised. Typically, an investment bank does not want to bear the risk of the whole agreement and instead forms a consortium of underwriters to sell parts of the total offer. It is important to remember that various stock exchanges have their own listing criteria as well. These need to be met before the listing could happen – for example, companies wanting to be listed at NSE should have a post-issue paid-up capital of at least Rs. 10 crore and post-issue market capitalization of not less than Rs. 25 crores. While for BSE, these values should be at least Rs. 3 crore.

Once the agreement is reached on the deal, the lead investment bank/ underwriter puts together a draft application with all the pertinent details about the issue and company data like financial statements, management background, any legal problems, where the capital raised will be used, insider holdings and the proposed ticker symbol that the company will use at the stock exchange. This document is submitted to the relevant regulatory body. Then, a cooling-off period is proposed during which the regulatory body caries out due diligence and verifies that all the material information about the company has been duly submitted. Once this offering is approved, the date (“effective date”) on which the offer will be made to the public is set.

During the cooling-off period the underwriter puts together a red herring prospectus. This is an initial prospectus and contains all the information about the company and the offer except the offer price and the effective date. This document is used by the underwriters and the company to market the company’s shares to public investors. Their aim is to build hype and interest in the issue. They would often put together a roadshow to court institutional investors and gauge the early demand for the shares.

Once the effective date is set, the company and the underwriters determine the optimum offer price based on the company’s ambition, response to the roadshow and the current market conditions. The IPO offer price is the price at which the company will raise capital for itself. Since after the initial sale, the shares will be traded on a secondary market (i.e. the stock exchange) the money will be made by the previous owner of the share and not the company.

It is clear that the underwriters target institutional investors and not individual investors with the IPO. This is because an individual investor hardly has enough money to justify the offer. For this reason, only a small percentage of the IPO allocation will be left for the individual investor and such investors will have to, on an average, apply to many lucrative IPOs before one is actually allocated to them.

The lack of historical data makes evaluating the fundamentals of a previously unlisted company very tricky. The only information available to individual investors is the red herring prospectus. While one should look for the usual information used to evaluate any listed company, special attention must be paid to the management team that has been put in place and where the capital raised would be invested. It is a good idea to compare this information with how other listed companies in the domain allocate their funds. Further, the quality of the underwriters is a good indicator of the company’s prospects. Be warier of offers backed only by smaller investment banks.

Looking at the share prices of newly listed companies, one usually finds a steep decline after a few months. This happens once the lock-up period associated with the offer expires. The lock-up period is the duration for which insiders like employees and officials of the company are not permitted to sell their shares. This period could vary from 3 months to 24 months based on the deal agreed with the underwriters. At the end of the lock-up period, most the insiders would try to book profit and the market will suddenly be flooded with shares putting severe downward pressure on the stock price. This could be a good opportunity to buy some shares (based on company fundamentals) if one had missed out on the IPO.

Flipping is the practice of selling the hot IPO stock at a high profit within the first few days of listing. While it is best to invest in a company with a long-term horizon, it is important to understand that this is standard practice for many institutional investors. This results in the share price overheating in the first few days after listing. Usually, the prices would come down to their real value in a matter of weeks. Therefore, it is better to not invest in a newly listed company if one misses out on the IPO. Better wait for the shares to be undervalued at the end of the lock-up period.

It is important to remember that underwriters are salespersons trying to push the price as high as possible. They would insist that this is a “once in a lifetime” opportunity – as the company will never be able to offer an IPO again. But as an investor one must be wary and know that most shares end up trading below the IPO price within a year of the offer. Of course, there will be few whose share price will keep on soaring. One has to identify these opportunities and buy IPOs only if they are a good investment and not just because it is an IPO.

Spin-offs and tracking stocks

Sometimes a company determines that a division would be worth more by itself, rather than as a part of a larger entity. In such a scenario, the company can decide to spin-off this division as a new company, and create tracking stocks for the new entity. For example, a company which is otherwise growing slowly may choose to spin-off a currently loss-making division with high growth potential as a separate entity. This will make raising funds for the new entity much easier than while it was part of the larger company. The parent company will typically stay on as the largest shareholder of the newly carved-out company. This strategy was seen in action when companies like Disney spun-off Internet companies during the dotcom boom. A similar strategy was used by established telecom operators when wireless technology first came to fore.

This is a win-win for the parent company as they get to retain control over the new entity, while all the expenses and revenues are separated from its own financial statements and shown as a subsidiary/ tracking stock instead. Further, if the spun-off entity turns out to be a great success, the parent company can purchase the stock back by offering its own stock and no cash at all.

It is important to remember that tracking stocks do not have voting rights in the parent company. The spin-off may not typically have a separate board of directors even. While not a normal IPO, a tracking stock IPO can nevertheless be a lucrative opportunity and may turn a good profit.

In conclusion, IPO is the first sale of stocks issued by a company to the public. While a private company is owned by a handful of closely-knit shareholders, a public company may have many thousands of shareholders. Despite the dilution of control, the lower cost of capital makes listing very attractive for new companies. While getting a piece of the IPO allocation may be difficult for individual investors, it could be a profitable investment when done after due caution. If one misses out on IPO, it is better not to invest in the company during the first few days as the share price may be overheated due to flipping. It is better to wait till the lock-up period expires and decide based on the company fundamentals then. Further, tracking shares may be a good investment opportunity if one understands the limitations it comes with – like a lack of voting rights.

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