Last updated on March 16, 2021
What is an IPO?
Many a times we have heard common news that a particular company is coming with its IPO. Hearing the news some of us usually question ourselves as to what is an IPO? Though the term seems to be a common one, most of us are not entirely aware of what an IPO is, what are the advantages and disadvantages of an IPO, what is the process of applying, and much more.
IPO Meaning
Initial Public Offering commonly referred as an IPO is a process where private companies offer their shares/stocks to public for investment by issuing new shares. IPO is a process by which small private companies raise the required capital to meet their business and working capital needs by undergoing outside financing. By selling shares the company is able to raise the required capital. However, the company has to satisfy a great deal of strict rules and guidelines mentioned by Securities and Exchange Board of India (SEBI). It is through the IPO that the owners of the company, for the first time, share the ownership of the company. Pervious to the allotment of shares through an IPO the company remains to be a privately owned company.
How does an IPO Works?
Most of the companies head towards taking bank loans, business loans, investments from private investors, or turn to venture capitals. However, there arises a point when the company needs more funds for the purpose of growing the business activities. This is where an IPO comes to play. Going public for a company through an IPO is a lengthy process.
Initially the company aiming to go public hires an investment bank to underwrite the IPO. The bank puts up a certain amount of money to fund the IPO and agrees on buying some shares offered by the company before they are offered to the general public. You must be wondering why banks fund an IPO. The reason behind this is the profit which banks get by buying the shares of the company at a price lesser than the price at which it is going to be sold to the general public.
After the underwriting process is completed, the IPO needs to be registered with SEBI. The registration document contains important information about the company issuing the IPO, its financial details, its objectives, and the ownership details of the company.
Once the registration is approved the underwriter drafts a prospectus. The underwriter also sets the initial offering price of the share, i.e., the price at which the share will be made available to the new investors.
Advantages of an IPO
An IPO brings in a lot of advantages with it. Here are some of them listed for you to consider.
It helps in raising funds: The first and the foremost advantage that an IPO offers the company is that it helps in raising funds for the company. After the company has gone for all modes of funding like bank loans, business loans, venture capital funding, and seed funding, IPO comes in as an added tool. By bringing an IPO in the market for the general public to invest in the company the company is able to raise the required amount of finances which are utilized for meeting out the business activities.
It offers an exit opportunity: There are various stakeholders who contribute a lot towards the growth and development of the company by investing both their time and money. These founders and investors find an IPO as a reliable and a significant tool to exit the company they have been associated with for such a long time.
To get the publicity: If the company continues to grow it becomes essential that the customers trust the products and services that the company is offering them. An IPO offers as an added tool that provides the company the required exposure by bringing the company to the spotlight. IPO acts as an informative tool that helps the investors decide whether they want to invest in the company or not. An IPO not only provides the company with a good amount of attention but also it helps company receive the required credibility by making it easier for the investor to take the decisions of investing in the company or not.
Reduces the cost of capital: Cost of capital acts as a major barrier for most of the companies, especially for the new companies. The bank loans are often offered at a higher rate of interest thereby raising the cost of the capital. On the other hand, IPO helps a company raise the required amount of capital at a reduced cost. It is also an easier mode for raising the required amount of capital.
Disadvantages of an IPO
Just like every good thing has a bad sign, offering an IPO too has some disadvantages that cannot be avoided by the companies considering it as a means to raise capital.
Additional Regulatory Requirements: Filing the financial statements for issuing the IPO to raise funds from the public requires a lot of regulatory work to be done by the company. This is a time consuming process as it involves a lot of scrutiny to be conducted on the part of the company.
Loss of Ownership: Though issuing an IPO seems to be a lucrative offer for the company as the cost of capital involved is low; it has the biggest disadvantage of sharing the ownership. Since the company offers equity shares to the public by offering an IPO it is sharing a part of its ownership with the public. There shareholders have the right to involve in the decision making processes of the company and also have the right to vote. This, in some cases, turns out to be disadvantageous for the company.
What is a New and Old IPO?
A new IPO, as the name suggests, is the one that is still open for the public to invest. It has been listed and opened for public offerings. An IPO remains open for three days after it has been issued to the public.
An old IPO on the other hand is the one which is closed for investment. The shares have been allotted in this case and no new investor can now invest in it any further.
Should you invest in an IPO?
In order to decide whether you should invest in an IPO or not, it is essential to look for a few things.
- Do the background check of the company that has come up with the IPO. Though it is certain that there might not be a good amount of historical data available since the company is new which is going public for the first time. In such case, it is essential to read the red herring prospectus of the company thoroughly. It provides all the details related to the IPO and the company issuing it for the first time.
- Look for the fact that who is underwriting the IPO for the company. If the underwriter is a small investment bank then it might not be good for investors to invest in the IPO of the company. IPOs that are backed by successful investment banks are suitable for investment.
- Look for the lockup period involved. A lockup period plays an essential role as it is the time period for which the investors cannot sell the shares of the company in case the company is not performing well. After the lockup period ends the price of the share tends to fall initially. Hence, it is important to check for the lockup period involved in the IPO.
Bottom Line
Since IPO is an easy and a go to mode of raising fund that is preferred by many companies to raise the capital amount required it is also a crucial tool. An IPO has pros and cons for both the general public as well as for the investors. It is essential for both the parties to have a complete analysis of the advantages and disadvantages that going public brings for them. Also, investing in an IPO should not be an impulsive decision. The investors need to check whether it is profitable to invest in a company or not.