What is an Initial Public Offering (IPO)

You must have come across a piece of news about IPO at least once in your life. And, if you are an investor or a trader of any stock market you might have applied for an IPO. You may have also researched whether applying for a certain IPO is a good choice or not. But, have you ever wondered what an IPO is?

The full form IPO is Initial Public Offering.

Let’s know more about an IPO.

What is an IPO?

Initial Public Offering, as the name suggests, is the process of offering shares of a private corporation to the public through new stock issuance. This offering allows a company to raise capital from the public and also gives the public a chance to be a shareholder of the company.

IPOs are offered to the general public through the primary market. Once the allotment process of the IPO is complete, the owners of the shares get the right to transfer their shares. And, this initiates the trading of such shares in the secondary market.

Every company needs to fulfill the legal requirements of the apex securities and exchange body of the country in which the IPO is to be held. For example, if a company is offering IPO in the USA share market, then  it has to comply with the requirements of the Securities and Exchange Commission (SEC). If the IPO is offered in India it will be bound by the rules of Securities and Exchange Board of India (SEBI).

Why do Companies Hold IPO?

Before offering its shares to the public, a company is considered private. A private company has a limited number of shareholders that may include founders, promoters, family, friends, and professional investors like venture capitalists and angel investors. Once the company reaches the saturation level of growth and expansion through private investment it needs much more capital to open the horizon of expansion.

It is at this level of business that a private company transitions into a public company by holding Initial Public Offering. The IPO greatly increases the company’s ability to grow and expand. And, this is also a great time for private investors to gain profit by selling their holdings to the public. The valuation of the shares is done through underwriting due diligence. And, the company has to fulfill all the regulatory requirements before listing its shares for initial public offering.

Where Do Proceeds from an IPO go?

You might wonder where the proceeds of an IPO go. The answer depends on the motto with which the IPO has been offered.

• Company – Proceeds go directly to the company when the IPO is held for raising fresh capital. This may then be utilized for expansion of the company, its future growth or paying off debt, etc.
• Promoters and Existing Investors – If the initial public offering is done by promoters or the investors for selling off their shares then the proceeds from the IPO go to them.

Types of IPOs

Based on the price, there are two types of IPOs

• Fixed Price Offering – Some companies decide to offer their initial shares to the public at a pre-determined price. This is called fixed-price IPO.
• Book Building Offering – In case the company decides not to fix a price, it can opt for Book Building Offering. In this offering, a 20% price band is set and the willing investors have the option to bid for the price they are willing to pay for that share.

Allocation of IPOs

When a company decides to offer its initial shares to the public it generally divides investors by category and a set percentage of the initial shares are offered to each category. Different categories for allocation of IPO may include –

• Non-Institutional Investors
• Qualified Institutional Buyers
• Retail Individual Investors

In addition to these categories, some companies offer shares to their employees and other categories related to them. Percentage form total offered shares for each category and number of allowed lots for each of them are pre-decided.

Allotment of Shares after IPO

When a company holds an initial public offering, different categories of investors including retail investors are required to bid for the shares. When you bid for certain lots of shares the amount needed to buy those shares is blocked in your account and it is said that you have subscribed to those shares. So, there can be two situations for a subscription –

• Oversubscription – This happens when investors have subscribed for more number shares than the available. Suppose, company X offered to sell 1000 shares and people have subscribed for 1500 shares then it is called oversubscription. When people have trust in the company making the initial offer then shares are usually oversubscribed.
• Under subscription – Needless to explain, this is a situation where a lesser number of applications for subscription is received as compared to the offered number of shares. This may happen with a company that fails to garner trust about its business and operation among the general public.

[The third situation where the number of application equals the number of offered shares is very unlikely to happen in real life situation.]

In most cases, shares during an IPO are oversubscribed. And in such cases, lottery system is used to determine who should get the share allotment and who should get the refund. If you are selected for allotment then the amount blocked in your account gets automatically deducted and you become the owner of the shares allotted to you. In case you do not get the allotment amount in your bank account is unblocked.

There’s nothing to worry about if you subscribe to an IPO and do not get the allotment of shares. The day those shares get listed on the stock exchange you can buy them from those who got the allotment just like you buy other shares in the stock market.