We are in the middle of a busy IPO season. Companies across the spectrum—from paints, housing, railways, IT services to miniratnas—are all looking to tap the market.
A lot of work goes into launching an IPO, which can take months if not more to hit the market. We look at various stages that go into the making of an IPO.
Why do companies go public?
When a company decides to expand its business, it needs capital which can be raised either in the form of debt, bonds or by selling ownership to the public (equity). To raise money through equity, it goes for what is known as an initial public offering (IPO). As the name suggests, the company offers its shares to the general public for the first time.
Enter merchant bankers
Having decided to go public, the first step is to appoint a merchant banker or a lead manager (LM). An IPO can have more than one merchant banker. The lead manager lays the ground for the IPO by preparing the draft red herring prospectus (DRHP).
DRHP, or the offer document, is a preliminary registration document prepared by merchant bankers for the company looking to launch the IPO.
The document contains information on the business activities, promoters, financials of the firm, etc. The lead manager also conducts due diligence on the company filing for an IPO.
What is underwriting and why does it matter?
Underwriting shares, vital to an IPO, is also done by the merchant banker. Underwriting involves determining the risk and the price of a security. During an IPO, investment banks first buy or underwrite the securities of the issuing company and then sell them in the market.
By underwriting shares, merchant bankers agree to purchase all or part of the IPO shares and resell them to the public. Underwriting is like insurance—it ensures that the company issuing the security can raise the full capital while earning the underwriters a premium in return for the service.
The next step
Marketing the IPO is also the job of the lead manager who also sees to the appointment of other intermediaries like registrars and bankers.
Once the intermediaries are appointed, the merchant banker has to formulate the issuing process of the shares.
Deciding the price
Broadly, there two ways to decide the price. One, where the company and the merchant banker fix a price called a fixed price. The other is where the company and lead manager agree on a price range and leave it to market forces to decide the final price known as book building.
In the book-building process, a price band along with the range is provided to investors. The applicants can bid for shares in the given range with the quantity for which they would like to bid.
The price at which the company wants to issue shares to the public is known as the offering or the issue price. The price is arrived at by the issuer in consultation with the merchant banker.
The company and the merchant banker/lead manager are expected to provide complete disclosures of the parameters they considered while assessing the price.
The basis for the issue price is disclosed in the bid document, in which the company provides extensive information on the qualitative and quantitative factors that support the bid.
Ready for launch
Once the merchant banker gets the green signal from the market regulator the Securities Exchange Board of India and the registrar of the companies, they are good to go for the IPO.
Also read: All About The IPO Allotment Process For Retail Investors
Lot size: It is important to understand the concept of lot size before understanding the process for allocation of shares in an IPO. The total equity shares provided by a company are grouped into smaller segments of shares known as lot size and each application made should be in lot size.
For instance, if a company needs to issue 1,000 shares and the size of the lot is determined as 10 shares per lot, then 100 x 10 = 1,000 shares are the total available lots. While applying for an IPO, the investor can apply only in absolute numbers.
When the subscription period ends, all the incorrectly submitted applications are deleted by the lead manager (merchant banker) to get the actual subscription number. It leads to two scenarios:
- Scenario 1:If the combined number of bid lots is less than the lots offered by the company, a full allocation is made to investors who have applied for the IPO.
- Scenario 2:The total number of bid lots is greater than the company's offered lots. In this case, there can be two sub-cases:
Small oversubscription: If the oversubscription is not too high, then every applicant is first issued one lot and the rest is allotted proportionately.
Large oversubscription: If the subscription is so high that even one lot of shares cannot be allocated to each eligible applicant, SEBI says the lots will be allocated on a lucky draw basis. The system of lucky drawing must be computerised and there must be no discrimination.
Once the allotment is done, the merchant banker allocates shares or refunds the money to investors.
The listing day
This is the day the company is listed on the stock exchange. The listing price is the price agreed on that day based on consumer demand and supply and the stock is listed at a cut-off price premium, par, or discount.
The day an IPO is issued, buy and sell orders may pile up until they are balanced against each other, deciding the opening price. Shares open higher than the offering price if the demand for the shares exceeds the supply and vice versa.Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.