By This article is part 7 of the Basics section of our Stock Market Learning series created by SMJ. It provides a clear and detailed explanation of what an Initial Public Offering (IPO) is, how it works, and the steps involved in investing in an IPO in the Indian stock market. Our goal is to help beginners understand the IPO process, recognize its advantages and risks, and feel more confident about participating in IPOs as part of their investment journey.
An Initial Public Offering marks a significant milestone in the life of a company, transforming it from a privately held entity into a public one. In simple terms, an IPO is the first time a company offers its shares to the public, allowing ordinary investors to buy a piece of the business. This process is crucial for companies that seek to raise capital for expansion, reduce debt, or simply increase their visibility in the market.
In the context of the Indian stock market, IPOs hold particular importance. The Securities and Exchange Board of India (SEBI), the regulatory authority overseeing the Indian capital markets, ensures that the IPO process is conducted transparently and fairly. This makes IPOs an attractive opportunity for investors looking to invest in potentially high-growth companies at an early stage.
Consider the IPO of Reliance Industries, which took place in 1977. This was one of the most significant events in the history of the Indian stock market. Since then, Reliance has grown into one of India’s largest conglomerates, and its IPO provided early investors with substantial returns. More recently, the IPO of Zomato in 2021 captured widespread attention, as it was one of the first major tech start-ups to go public in India, reflecting the growing interest in digital and tech-driven businesses.
For both companies and investors, IPOs can be a double-edged sword. They offer the potential for significant growth and returns, but they also come with risks and challenges. Understanding what an IPO is, how it works, and its implications in the Indian market is essential for anyone looking to participate in the stock market.
Also Read: Long-Term Investment in Stock Market – What, Why, How?
How an IPO Works
Before a company can offer its shares to the public through an Initial Public Offering (IPO), it operates as a private entity. In this private phase, ownership is typically restricted to the company’s founders, early investors like venture capitalists, and possibly a small group of employees or close associates. However, as the company grows and requires more capital to expand, it may decide to go public, allowing a broader pool of investors to participate in its future.
The Transition from Private to Public
The process of transitioning from a private company to a publicly traded one begins with the decision to go public. This decision is often made when the company has reached a certain level of maturity, profitability, and market valuation, which suggests it can withstand the scrutiny and responsibilities of being a public entity. In India, companies planning to go public must adhere to strict guidelines set by the Securities and Exchange Board of India (SEBI), ensuring that the interests of investors are protected.
The Role of SEBI
SEBI plays a crucial role in regulating the IPO process in India. Before a company can list its shares on the stock exchange, it must file a detailed document known as the Draft Red Herring Prospectus (DRHP) with SEBI. This document provides potential investors with comprehensive information about the company’s business model, financial health, and future prospects. SEBI reviews the DRHP to ensure that the company has disclosed all necessary information and that the IPO process is transparent.
The Role of Underwriters
One of the key players in an IPO process is the underwriter, usually an investment bank or a consortium of banks. The underwriter’s primary responsibility is to guide the company through the IPO process, which includes pricing the shares, marketing the offering to potential investors, and ensuring that the shares are sold. In India, major financial institutions like ICICI Securities, Kotak Mahindra Capital, and Axis Capital often act as underwriters.
The underwriter assesses the company’s value using various financial models and sets an initial share price. This price is crucial because it determines how much capital the company will raise from the IPO. The underwriter also manages the risk by purchasing any unsold shares during the IPO, ensuring that the company raises the desired funds.
The IPO Process in India
Once the DRHP is approved by SEBI and the underwriter has set the price range, the company can move forward with the IPO. The shares are offered to institutional investors, retail investors, and High Net Worth Individuals (HNIs) through a bidding process in what is known as the book-building phase. In this phase, investors place bids for shares within a specified price band, and the final issue price is determined based on the demand.
After the bidding process is complete and the shares are allocated, the company lists its shares on the stock exchange, typically the Bombay Stock Exchange (BSE) or the National Stock Exchange (NSE). On the listing day, the shares are available for trading to the public, marking the company’s official transition from a private to a public entity.
The Listing Day and Beyond
The listing day is a critical moment for any company going public. The share price can experience significant volatility as it begins trading in the open market. The performance of the stock on its first day often sets the tone for its future market performance. Companies like TCS and Infosys, which have had successful IPOs in India, saw their share prices soar on the first day of trading, reflecting strong investor confidence.
The IPO process is a complex journey that transforms a private company into a public one, opening up opportunities for a broader range of investors to participate in its growth. With the stringent regulations by SEBI and the expertise of underwriters, the process is designed to be transparent and fair, ensuring that both the company and the investors can benefit from this crucial step in the business lifecycle.
Types of IPOs
When a company decides to go public, it can choose between different methods to offer its shares to investors. In the Indian stock market, the two most common types of IPOs are Fixed Price Issues and Book Building Issues. Understanding these types is crucial for investors as each method has different implications for how the shares are priced and sold.
Fixed Price Issue
In a Fixed Price IPO, the company sets a specific price for its shares before the IPO opens for subscription. This price is determined based on the company’s valuation, future growth prospects, and the recommendations of the underwriters. Investors know this fixed price in advance and can decide whether they want to subscribe to the IPO at that price.
- Pricing – The fixed price is pre-determined, and all investors who apply for shares in the IPO pay this price.
- Demand Discovery – The share demand is only discovered after the IPO closes. If the shares are oversubscribed, they are allotted on a proportionate basis.
- Investor Participation – Investors must pay the full price of the shares when they apply for the IPO.
Book Building Issue
The Book Building process is more flexible and is the most commonly used method for IPOs in India. In this type of IPO, the company does not set a fixed price. Instead, it offers a price band—a range within which investors can place their bids. The final price of the shares is determined based on the demand generated during the bidding process.
- Price Band – The company and its underwriters decide on a price band (e.g., ₹100-₹120 per share). Investors place bids within this range, indicating how many shares they want to buy and at what price.
- Demand Discovery – As bids come in, the company gauges the demand for its shares at various price levels. The final issue price is set at a level that reflects this demand, typically at or near the upper end of the price band if demand is high.
- Investor Participation – Investors only need to pay the highest price within the band at the time of application. The difference is refunded if the final price is lower.
Differences Between Fixed Price and Book Building Issues
- Pricing Transparency – In Fixed Price Issues, the price is known beforehand, while in Book Building Issues, the price is only finalized after the bidding process.
- Demand Discovery – Fixed Price Issues discover demand post-IPO, whereas Book Building Issues gauge demand during the IPO process itself.
- Investor Payment – In Fixed Price Issues, investors pay the entire amount upfront, while in Book Building Issues, they initially pay based on the upper limit of the price band.
Advantages of Investing in IPOs
Investing in an Initial Public Offering (IPO) can be an exciting opportunity, especially in a growing market like India. IPOs offer investors the chance to get in on the ground floor of a company’s public journey, often with the potential for substantial returns. However, it’s important to understand the specific advantages that make IPOs attractive to investors.
Early Entry into High-Growth Companies
One of the most significant advantages of investing in an IPO is the opportunity to buy shares of a company at the start of its public market journey. If the company performs well, the value of its shares can increase significantly over time. Being an early investor allows you to potentially benefit from the company’s growth as it expands and gains more market visibility.
Potential for Significant Returns
IPOs often attract attention because of their potential to deliver significant returns in a short period. If the market reacts positively to the IPO, the stock price can surge, sometimes even doubling or tripling in the initial days of trading. This potential for rapid appreciation is one of the main draws for investors.
Portfolio Diversification
Investing in IPOs can be a way to diversify your investment portfolio. By purchasing shares of a newly public company, you can add exposure to different industries or sectors that may not be represented in your existing investments. Diversification helps reduce risk by spreading your investments across various assets.
Access to Innovative and Emerging Sectors
Many companies that go public through IPOs are in innovative or rapidly growing sectors, such as technology, healthcare, or renewable energy. Investing in these IPOs can provide exposure to new and emerging industries that have the potential for significant growth.
Visibility and Transparency
When a company goes public, it is required to adhere to strict regulatory standards set by SEBI, including regular financial disclosures and audits. This increased transparency provides investors with more information to make informed decisions. Additionally, public companies often attract more media and analyst coverage, giving investors access to a wealth of information that may not be available for private companies.
Participation in India’s Economic Growth
By investing in IPOs, you are participating in the growth of the Indian economy. Many companies that go public are looking to expand and contribute to sectors that are crucial for India’s development. As these companies grow, they not only provide returns to their investors but also play a role in the overall economic progress of the country.
Risks and Challenges of Investing in IPOs
While investing in Initial Public Offerings (IPOs) can offer exciting opportunities, it’s important to understand the risks and challenges involved. IPOs are inherently risky, and not every public offering results in a successful investment.
Market Volatility
One of the most significant risks associated with IPOs is market volatility. When a company goes public, its stock price can fluctuate wildly, especially in the early days of trading. This volatility is often driven by investor speculation, market sentiment, and external factors such as economic conditions or political events. The initial surge in stock price can be followed by sharp declines, leading to potential losses for investors.
Limited Historical Data
Unlike established companies, which have years of financial records and performance data, newly public companies have limited historical data available to investors. This makes it challenging to assess the company’s true value and growth potential. Investors must rely heavily on the information provided in the prospectus and may face uncertainty about the company’s ability to meet its projected goals.
Overvaluation Risk
IPOs can sometimes be overhyped, leading to overvaluation of the company’s shares. When a company is overvalued, its stock price is higher than what its fundamentals justify. This can happen when there is excessive demand during the IPO process, pushing the price beyond the company’s actual value. If the market corrects this overvaluation, the stock price may drop, resulting in losses for investors who bought at the inflated price.
Lock-Up Period Expirations
After an IPO, there is often a lock-up period during which company insiders, such as founders, employees, and early investors, are restricted from selling their shares. Once this lock-up period expires, a large volume of shares may be released into the market as insiders begin to sell. This can lead to a sudden increase in supply, causing the stock price to drop sharply.
Uncertain Long-Term Performance
Investing in an IPO is not just about short-term gains; the long-term performance of the stock is crucial. However, predicting the long-term success of a newly public company is challenging. Many companies face difficulties in maintaining growth after going public, and some may struggle with profitability or market competition, leading to disappointing long-term returns for investors.
Regulatory and Compliance Risks
Public companies in India are subject to stringent regulatory requirements and compliance obligations set by SEBI. While these regulations are designed to protect investors, they can also pose challenges for newly public companies. The costs and efforts associated with meeting these regulatory requirements can strain a company’s resources, particularly if it is not fully prepared for the transition from private to public.
Dilution of Ownership
When a company issues new shares through an IPO, the ownership stakes of existing shareholders are diluted. While this is a common part of the IPO process, it means that the percentage of ownership held by early investors and insiders decreases, which can affect their control over the company’s decisions and future direction.
How to Invest in an IPO in India
Investing in an IPO can be a great way to participate in the early growth stages of a company. However, the process of investing in an IPO in India involves several steps and requires a clear understanding of the application process, eligibility criteria, and important considerations. Here’s a step-by-step guide on how to invest in an IPO in India.
Step #1 – Eligibility and Requirements
Before you can invest in an IPO in India, you must meet certain eligibility criteria –
PAN Card – You must have a Permanent Account Number (PAN) issued by the Income Tax Department of India. This is mandatory for all financial transactions in the stock market, including IPO applications.
Demat Account – You need to have a Demat account to hold your shares electronically. A Demat account is where your shares are stored, similar to a bank account that holds your money.
Trading Account – While a Demat account is required to hold shares, a trading account is needed if you plan to sell your shares after listing. Most brokers provide both Demat and trading account services together.
Step #2 – Choosing the Right Broker
To invest in an IPO, you need to apply through a broker or a bank that provides IPO investment services. There are two main types of brokers –
Full-Service Brokers – Offer a wide range of services including investment advice, research, and a dedicated relationship manager. They typically charge higher fees.
Discount Brokers – Provide basic trading services at lower costs but with limited support and advisory services.
Step #3 – Understanding the IPO Prospectus
Before applying for an IPO, it’s crucial to read the company’s Draft Red Herring Prospectus (DRHP), which is filed with SEBI. The DRHP contains detailed information about the company’s business model, financial performance, risks, and plans for using the funds raised through the IPO.
Key Sections to Review –
Business Overview – Understand what the company does and how it plans to grow.
Financial Statements – Review the company’s financial health, including revenue, profit margins, and debt levels.
Risk Factors – Pay attention to any risks highlighted by the company that could impact its future performance.
Also read: Introduction to Fundamental Analysis: What, Why, and How?
Step #4 – Application Process – ASBA
In India, IPO applications are processed through the Application Supported by Blocked Amount (ASBA) system, which is a safe and efficient way to apply for shares.
ASBA Process –
- Login to Your Broker’s Platform – Access the IPO section on your broker’s trading platform.
- Select the IPO – Choose the IPO you want to apply for from the list of available offerings.
- Enter Bid Details – Specify the number of shares you want to apply for and the bid price. In a book-building IPO, you can choose the cut-off price to increase your chances of allotment.
- Submit Application – Once you confirm the details, submit your application. The application amount is blocked in your bank account but not debited until shares are allotted.
- Confirmation – You will receive a confirmation message from your broker and the bank once the application is successfully submitted.
Step #5 – Allotment and Listing
After the IPO application process closes, the company and underwriters determine the final issue price and allocate shares to investors. The allotment status is usually announced a few days after the closure of the IPO.
Allotment Status – You can check the status of your allotment on the registrar’s website or through your broker. If you receive an allotment, the shares will be credited to your Demat account. If you do not receive any shares, the blocked funds will be unblocked in your bank account.
Listing Day – The company’s shares will be listed on the stock exchange (NSE or BSE), and you can begin trading. On the listing day, the share price can experience significant volatility, so it’s important to monitor the market closely if you plan to sell your shares.
Step #6 – Post-IPO Considerations
Monitoring the Stock – After the IPO, keep an eye on the company’s performance and stock price movements. IPO stocks can be volatile, so it’s essential to stay informed about any news or developments related to the company.
Long-Term vs. Short-Term Holding – Decide whether you want to hold the stock for the long term or sell it shortly after listing. This decision should be based on your investment goals and the company’s prospects.
This article is a foundational step in understanding IPOs in the Indian stock market. While we strive to provide accurate and up-to-date information, investing in the stock market involves significant risks, and there are no guarantees of profit. The value of investments can fluctuate, and you may not recover the full amount you originally invested.
The examples and companies mentioned in this article are for illustrative purposes only and should not be construed as recommendations for investment. We do not endorse any specific stocks, companies, or financial strategies, nor do we encourage making investment decisions without thorough research and understanding.
It’s crucial to conduct your own research or consult with a financial advisor to develop an investment strategy tailored to your individual goals and risk tolerance. Follow the entire series to gain a comprehensive understanding and become a knowledgeable investor. Always invest wisely, considering your financial objectives and risk appetite before making any investment decisions.
