IPO: A Money-Making Process

An Initial Public Offering, better known as IPO, is the very first time a private company issues its shares to the public. In other words, it is the ‘sharing’ of ownership with the public or investors’. These investors buy a stake in the company, which is valued through the shares issued, and consequently, the company gets to raise capital for its growth.

Let’s take a hypothetical example of Frank Castle who has a thriving utensil-manufacturing business. Frank has one factory operating at maximum capacity and wishes to expand it. He also needs more capital to source materials internally to reduce costs. However, he already has a sizeable amount of debt owed to the bank and wants to avoid taking another loan.

For Frank, it would be wise to sell part ownership of his business to the public at large. The capital raised through this could then be used to pare existing debt and enable his business to grow. If the company heads in the intended direction, the investors stand to make a lot of money for themselves.

However, to make an IPO, Frank would also incur significant marketing, accounting, and legal costs. A substantial amount of attention, time, and, effort would be required to follow the protocol. Only companies that meet the requirements of the market watchdog Securities and Exchange Board of India (SEBI) are eligible to float IPOs. An investment bank or other financial institution is also needed to act as an underwriter to the company. The underwriters buy the shares from the company and then sell them to the public. The company also has to prepare a prospectus, called a draft red herring prospectus, that includes detailed financial records, future plans, and the expected price range of the shares for prospective investors. Valuation of the IPO, in particular, can get fairly complicated for newer companies.

After SEBI approval is received, the company, with the help of underwriters, decides on the price band and number of shares to be sold. Issues are mostly of two types: fixed price issue — where the company decides the price and number of shares to be issued; and book building issue — where the price is discovered through bidding. Finally, the shares are made available to the investors on the date mentioned in the prospectus.

A demat account is a prerequisite for an investor to bid for an IPO. They would need to fill an IPO form which can be obtained from a broker and write a cheque for the desired number of shares. Once the price is decided, shares are allotted to investors based on the bids and the unsold shares are made available with the underwriters. Today, this process can also be done online. Several trading applications and websites have made it easier to trade online and get share market tips constantly. For trading in shares, however, an investor must have a trading account.

Investing in stocks can be a great alternate source of income for anybody. Specifically, in the case of IPOs, the opportunities to grow significantly outweigh the potential risks. True, no investment is a sure thing, but with enough research and scrutiny, IPOs can provide huge gains over the long term. To quote Warren Buffet, “If you don't find a way to make money while you sleep, you will work until you die.”