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IPOs, or initial Public Offerings, have become one of India’s most trending investment-related topics due to the immense wealth some of them have generated over the past couple of years. IPOs like Devyani International Limited, Data Patterns (India) Limited, and Happiest Minds Technologies Ltd are some names that have at least doubled the initial investment amount.
At the same time, companies see IPOs as one of the most effective ways to take growth to the next level. Through the IPO, the company raises funds by going public and offering its shares to the general public. Those funds are used to finance future projects and venture into new businesses. The launch of an IPO may be beneficial to both companies and investors.
However, a private company cannot arbitrarily decide it wants to launch its IPO and list itself on the stock exchanges tomorrow. How does an IPO work, then?
Process of Launching an IPO
To answer the question, “How does an IPO work?”, we must first understand the pre-launch process. The private company coming out with its IPO has to go through a lengthy pre-launch phase, also called the pre-marketing phase. In this stage, the company fulfills the necessary formalities to seek approval from the SEBI (Securities and Exchange Board of India), the regulatory body of the stock market in India.
Simultaneously, it hires underwriters, lawyers, and certified public accountants to help determine different facets of the IPO. Underwriters, consisting of investment bankers, are at the forefront of the process, going through the company’s books, evaluating the company’s financial needs, and helping decide the company’s value. On this basis, they decide the IPO price band and the number of shares issued in the offer. They draft the application to SEBI seeking approval and provide the company’s past financial statements, debt and asset records, and net worth. SEBI audits the application and gives the go-ahead to sign if the company fulfills the essential requirements.
The company then releases its Red Herring Prospectus (RHP) to the public. This RHP is a document that contains the number of shares to be issued, the price band, and the company’s past financial performance. In conjunction with that, executives meet with potential institutional investors to offer investment proposals.
Applying for the IPO
Finally, after all of the above is over, the company announces its IPO subscription window. This subscription window generally spans three trading days, when retail investors can place bids to invest in the IPO. There are three categories through which investors can place bids: institutional, HNI (High Net-worth Individual), and retail. As a regular investor, you generally apply through the retail category. So, to invest in an IPO, you must have a demat account with a broker like Share India. You use your Demat account app and go to the IPO section to place your bid and block funds for the IPO.
Your bid must be within the provided price range. At the same time, remember that IPOs are issued in lots, and every lot contains a specific number of shares. So, as an investor, you can bid for a minimum of one lot. For example, the price band could be between ₹1470 and 1500, and the lot size could be ten shares. In this case, your minimum bid per lot would be ₹14,700, while the maximum bid per lot is ₹15,000. However, you can bid on multiple lots. If your bid entails multiple lots and exceeds ₹2 lakh, your application will qualify as an HNI application.
Based on the total number of bids, investors will be allotted shares, and on the listing date, the IPO will be listed on the stock exchanges like the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE). After the company is listed, investors can start trading the stock like other listed stocks. If you were not allotted shares in the IPO, you could buy shares after it is listed on the stock exchanges. However, before applying for any IPO, conduct thorough research on the company.
Oversubscription in IPOs
In the previous section, there is an indication that not all bids end up bearing fruit. In other words, every investor’s bid will not be successful if the IPO is oversubscribed. Simply put, when the total number of bids exceeds the total number of shares available, the IPO is oversubscribed. Let us understand the concept of oversubscription with the help of an example.
Consider a company that is launching its initial public offering (IPO), issuing 1000 lots of shares, and you bid for two lots as a retail investor. However, if there are more than 1000 bids, the registrar will allot shares in such a manner that every investor gets at least one lot. However, the number of bids often exceeds the number of available shares to such an extent that it is impossible to even allot one lot of shares to every bidder. In that case, a lottery is conducted, and one lot is allotted to each applicant who is drawn.
Lock-Up Period in IPOs
So, now you understand how an IPO works when it comes to applying for one. However, we also need to look at the post-launch particulars. The lock-in period is an essential aspect of IPOs when discussing how they work. As a retail investor, you are exempt from lock-in periods. Nonetheless, you must know what it entails.
The lock-in period defines the period for which investors must hold onto their shares. Investors subjected to lock-in periods generally hold a large proportion of the total shares, like institutions, insiders, and anchor investors. The lock-in period binds such investors to remain invested in the company for a specified period. This lock-in period may generally span 6–12 months in India and may differ from investor to investor. This time period helps the firm establish itself in the markets before allowing investors to cash out. You need to know about this period because when the lock-in period ends, there may be heavy selling activity.
Conclusion
So, if you’re wondering, “How does an IPO work?” you’ve got your answer. Now the next question is, Should you be investing in IPOs? Now, like any other investment, there are pros and cons to investing in IPOs. If you want to invest in those, avoid investing in IPOs that launch at obscene valuations. Some companies take advantage of the IPO frenzy and launch their IPOs at obscene valuations. Those IPOs might have generated returns upon listing but may be trading way below their listing price today.