Initial Public Offering (IPO), Terms, Process, Advantages, Disadvantages

An Initial Public Offering (IPO) is the process by which a private company becomes publicly traded by offering its shares to investors for the first time on a stock exchange. This allows the company to raise capital for expansion, debt repayment, or other financial needs. The IPO process involves regulatory approvals, pricing, and underwriting by investment banks. Once listed, the company’s shares are freely traded in the stock market. IPOs provide investors with an opportunity to own equity in a growing company while enabling businesses to access public funding and enhance their market visibility and credibility.

General Terms involved in an initial public offering (IPO):

1. Issuer: The company that offers its shares to the public through an IPO to raise capital. It transitions from private to public ownership.

2. Underwriter: Investment banks or financial institutions that manage and facilitate the IPO process, including pricing, marketing, and share allocation.

3. Prospectus: A legal document providing detailed information about the company’s financials, business model, risks, and IPO details, helping investors make informed decisions.

4. Offer Price: The price at which shares are initially issued to investors. It is determined through book-building or fixed price methods.

5. Book Building: A price discovery process where investors place bids within a price range, and the final issue price is determined based on demand.

6. Fixed Price Issue: The company sets a pre-determined price for its shares, and investors subscribe at that price. Demand is known only after the issue closes.

7. Lot Size: The minimum number of shares an investor can apply for in an IPO, defined by the issuing company.

8. Subscription: The demand for IPO shares. If demand exceeds supply, the IPO is oversubscribed; otherwise, it is undersubscribed.

9. Allotment: The process of distributing shares to investors based on their IPO applications. If oversubscribed, shares are allotted via a lottery system.

10. Listing: The process where IPO shares get listed on a stock exchange (NSE, BSE), enabling public trading of the company’s stock.

Process involved in an initial public offering (IPO)

1. Underwriting

IPO is done through the process called underwriting. Underwriting is the process of raising money through debt or equity.

The first step towards doing an IPO is to appoint an investment banker. Although theoretically a company can sell its shares on its own, on realistic terms, the investment bank is the prime requisite. The underwriters are the middlemen between the company and the public. There is a deal negotiated between the two.

E.g. of underwriters: Goldman Sachs, Credit Suisse and Morgan Stanley to mention a few.

The different factors that are considered with the investment bankers include:

• The amount of money the company will raise
• The type of securities to be issued
• Other negotiating details in the underwriting agreement

The deal could be a firm commitment where the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public, or best efforts agreement, where the underwriter sells securities for the company but doesn’t guarantee the amount raised. Also to off shoulder the risk in the offering, there is a syndicate of underwriters that is formed led by one and the others in the syndicate sell a part of the issue.

2. Filing with the Sebi

Once the deal is agreed upon, the investment bank puts together a registration statement to be filed with the SEBI. This document contains information about the offering as well as company information such as financial statements, management background, any legal problems, where the money is to be used etc. The SEBI then requires cooling off period, in which they investigate and make sure all material information has been disclosed. Once the SEBI approves the offering, a date (the effective date) is set when the stock will be offered to the public.

3. Red Herring

During the cooling off period, the underwriter puts together there herring. This is an initial prospectus that contains all the information about the company except for the offer price and the effective date. With the red herring in hand, the underwriter and company attempt to hype and build up interest for the issue. With the red herring, efforts are made where the big institutional investors are targeted (also called the dog and pony show).

As the effective date approaches, the underwriter and the company decide on the price of the issue. This depends on the company, the success of the various promotional activities and most importantly the current market conditions. The crux is to get the maximum in the interest of both parties.

Finally, the securities are sold on the stock market and the money is collected from investors.

Advantages of coming up with an IPO:

• Access to Capital for Growth

An Initial Public Offering (IPO) enables a company to raise substantial capital from public investors. This funding can be used for business expansion, research and development, acquisitions, debt repayment, and infrastructure growth. Unlike bank loans or private equity, IPO funds do not require repayment, reducing financial burdens. With more capital, companies can invest in innovation, expand into new markets, and increase operational capacity, ensuring long-term sustainability and competitiveness in their industry.

• Increased Public Awareness and Market Credibility

Going public enhances a company’s brand visibility and credibility in the market. Being listed on a stock exchange like NSE or BSE attracts media attention, analysts, and institutional investors, boosting the company’s reputation. This credibility helps in gaining customer trust, attracting new business opportunities, and securing strategic partnerships. A public company is perceived as more transparent and financially stable, which strengthens investor confidence and improves long-term business prospects.

• Liquidity and Exit Opportunity for Early Investors

An IPO provides an exit strategy for early investors, founders, and venture capitalists who seek to realize returns on their investments. Unlike private funding, where selling shares can be complex, a public listing allows shareholders to sell their stakes in the open market. This liquidity increases investor interest in the company, making it easier to attract future investments. Employees with stock options (ESOPs) also benefit by monetizing their shares post-listing.

• Ability to Use Stock as Currency

Publicly listed companies can use their shares as non-cash currency for mergers, acquisitions, and employee compensation. This means that instead of paying cash for acquisitions, they can issue new shares, preserving liquidity while expanding their business. Additionally, offering stock-based incentives to employees improves retention and motivation, aligning employee interests with company performance. This flexibility makes IPOs an attractive option for companies looking to grow strategically without heavy financial burdens.

• Improved Corporate Governance and Transparency

Going public requires companies to adhere to stricter regulations and disclosure norms, improving corporate governance. Listed companies must publish financial reports, undergo audits, and follow SEBI guidelines, ensuring transparency and accountability. This structured governance framework enhances investor confidence, reduces operational risks, and leads to better decision-making. Improved governance also helps in securing further investments from institutional investors, ensuring long-term sustainability and trust in the financial markets.

Disadvantages of Coming up with an IPO:

• High Costs and Expenses

Launching an IPO involves significant costs, including underwriting fees, legal expenses, regulatory compliance costs, and marketing expenses. Companies must hire investment banks, auditors, and legal advisors, making the IPO process expensive. Additionally, after listing, ongoing costs for financial reporting, compliance, and shareholder communication increase the financial burden. These costs may outweigh the benefits, especially for smaller firms with limited capital, making IPOs a less viable option compared to other funding sources.

• Loss of Control and Ownership Dilution

When a company goes public, founders and existing shareholders lose a portion of their ownership as shares are distributed among public investors. This dilution can lead to a loss of control, especially if institutional investors or activist shareholders acquire a significant stake. Public companies must also consider shareholder interests in decision-making, which can limit flexibility and independence in business operations. Major decisions may require board approval, reducing management’s autonomy in strategic planning.

• Regulatory and Compliance Burden

Public companies must adhere to strict regulations imposed by SEBI (Securities and Exchange Board of India) and stock exchanges. They are required to disclose financial statements, conduct regular audits, and follow corporate governance norms. Any failure to comply can result in penalties, legal actions, or delisting. The increased scrutiny demands transparency in operations, making it difficult for companies to keep certain strategic or financial information confidential, which could impact their competitive edge.

• Market Volatility and Stock Price Fluctuations

Once listed, a company’s stock price is subject to market conditions, investor sentiment, and economic factors. External events such as economic downturns, political instability, or industry trends can lead to extreme fluctuations in share prices, affecting the company’s valuation. A declining stock price may create negative investor perception, reducing the company’s ability to raise additional funds. Management may also face pressure to meet short-term earnings expectations rather than focusing on long-term growth strategies.

• Increased Public and Investor Pressure

A public company is accountable to shareholders, analysts, and regulators, which increases pressure on management to deliver consistent financial performance. Investors expect regular profits, dividends, and stock price growth, forcing companies to prioritize short-term performance over long-term strategies. Additionally, the risk of hostile takeovers increases as external investors accumulate shares. Management must spend significant time handling shareholder concerns, investor relations, and public disclosures, which can divert attention from core business operations.

• Risk of Underperformance and Delisting

Not all IPOs succeed. If a company fails to meet investor expectations or generates lower-than-expected profits, its stock price may decline. Poor market conditions, weak financials, or mismanagement can lead to low demand for shares, resulting in poor post-IPO performance. In extreme cases, if a company fails to maintain compliance standards or sustains financial losses, it may face delisting from stock exchanges, leading to a loss of investor confidence and reputation damage.