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IPOs: A Quick Overview

A company has ownership i.e. there are one or more person(s) or financial entities who own the entire company – all its tangible and intangible assets, movable and immovable resources, including the loans and bill payments it has to make to others (called debt). For private companies, it will be a person, a family or a group of people, friends etc. For a government-held company, it is could be the relevant ministry or the head of the nation (as per the norms of the country).

The total value of the company ( to define in the simplest way ) is the value of all of its assets minus the value of the loans and payments it has to make. This total value is called equity.

By all assets, it means everything the company has in its possession – the deposits in bank accounts, the ready cash, the real estate, the value of investments it might have made in other companies, the values of its assets like land, buildings, furniture, cars, transport, office accessories and everything else that can be related to its ownership. These entities add to the equity value. Along with it, the company would have taken some loans and also it might have to make some payments like electricity bills, office rents, employee salaries, taxes etc. These are all collectively called debt and this value is subtracted from the asset value to give a final value called EQUITY value. This equity value is divided into a number of small units called shares and these shares are divided among the owners of the company. Thus each stakeholder of the company would hold some number of shares based on the money he or she would have invested in the company.

There will be times when these owners of the company might want some more money for business requirements or they might want to sell their stakes to someone else. Few might do so privately by getting into business deals and selling off their stakes to selected one or more persons or financial groups. Stock markets provide a kind of alternative to do so. Companies can sell a part of their stakes to the general public. When they do so, people who buy stocks in their companies would also become shareholders in their companies. The process of selling privately held shares to the general public for the FIRST time is called IPO. Once the IPO process completes, the company is listed in the share markets and the "publicly held shares" can be traded in the open market.

IPO stands for Initial Public Offer.

It is a process by which the owner(s), promoter(s) and early investor(s) of a company sell their stake (fully or partly) in the company to other financial entities like institutional investors (Mutual Fund Houses, Insurance Firms, Banks, Pension Fund Houses, Private Equity Investors etc) or retail investors (general public) through stock market.

In order to sell its shares, the company needs to take assistance from large financial institutions (generally called investment banks or merchant banks). These investment banks compute the valuation of the stocks to be sold. This process is called book building. They also make arrangements for these stocks to be sold to the buyers and get them listed in the stock markets. These large financial firms offering such services also provide some sort of insurance to the companies selling its stake. In event that there are not enough buyers for such stocks, these investment banks would buy a part of those stocks. In return, these investment banks levy brokerage charges on the company selling it stock. In other words, they buy the shares from the company at a lower price and sell it off in the open market at a higher price and keep the difference between the two prices with them.

The company selling the stocks is called ISSUER. The large financial firms acting as intermediaries are called UNDERWRITERS. The final entities who buy such stocks are called SUBSCRIBERS or simply INVESTORS.

Why does a company ever need to go PUBLIC at all? Why not remain 100% private?

There are at times when a company needs some money to accomplish some of its goals – like fundraising to expand its business or repay a loan (debt). It can, of course, take a loan from banks and other financial institutions to accomplish these tasks but those loans come at much higher interest rates. Whereas it is much more cost effective to sell a part of your equity shares in the open market.

To illustrate, suppose you are a farmer in possession of 100 acres of land and produce 100 KG of rice every year. To increase your farm output, you do some diligence and assessment and finally arrive at the conclusion buying a new high-tech tractor would help to double the farm output to 200 KG. You can take a loan from a bank to buy a tractor. At the same time, you also make some assessment that instead of cultivating 100 acres of land, you can cultivate only 75 acres and still produce around 150-160 KG of rice. So you decide that instead of taking a loan from a bank which comes with substantial interest, you should mortgage (or even sell) 25 acres of your land to another person and the amount of money you get in turn could be used to buy a tractor. Overall, you would still be making profits and earning more profits. Over the period of time, say in 5 to 10 years, you can still set your mortgaged land free. The same principle is applied by companies who wish to go public. (At times companies do have a buy-back scheme where they buy some of the shares back from the public at the prevailing market rate).

There is another reason why a company might want to go PUBLIC. The promoters and investors might feel that there is not much scope in future prospects of the company and might wish to exit their positions by selling off their stakes to someone else. Just like, as in the example illustrated above, the farmer might not see much hope in agriculture (possibly because of new government norms or climatic changes, personal inability to continue farming etc. ) and might wish to sell off his land and get away with cash at hand. This is a negative scenario, though less in occurrence, where companies might want to go public.

Once the company shares are available in the stock market (also referred to as the open market at times), it is called a Listed Company. Once a company is listed, its shares can be traded by the general public in the open market. This is also referred to as Free Floating of shares – meaning shares pass from one hand to another hand.

Advantages of IPO

1) Provides a means for the company to raise money to accomplish some of its financial goals.

2) There is always a difference in the price of the shares at which the IPO shares are sold (subscription or bidding price) and the price at which they are listed in the shared markets (called listing price). In most cases, the listing price is more than the bidding price and hence there is an opportunity for the traders and short-term investors to make some cash gains when these IPOs are listed. These gains are called listing gains.

3) If the company is good and outperforming, it gives an opportunity to the general public to have direct shareholdings (or indirect holding through mutual funds). With the consecutive growth of the company, the market value of the company rises and hence the valuation of the shares that one holds.

4) Because of the rules and regulations of the governments, all listed companies have to be transparent in their financial audits. Such a fair audit increases the trust of the public and financial institutions in such companies which in turn will invest further.

5) The list companies have to conduct stakeholder meetings and vote from time to time. As such general public and financial institutions get a decision-making opportunity in such companies.

6) A listed company earns more market reputation and credibility and is likely to expand more and also gain more footing at national and international levels.

Disadvantages of IPO

1) Not all companies are outperforming and have solid futures. At times, the promoters and early investors (people who have invested money initially in companies when they were privately owned) might want to exit from such companies. IPOs are one such legal mechanism for such exits. Hence one needs to exercise caution when he or she intends to subscribe to an IPO. This is more common for government-held companies wherein most of the time, in name of disinvestment, the government simply wants to get rid of underperforming entities.

2) At times, market conditions or timings or certain news or events might result in the listing price is lower than the subscription price resulting in devaluation of your money invested or loss for the short-term traders.

3) IPOs are generally awarded undemocratically i.e. a major portion is reserved for large institutions and High Net Worth (HNI) individuals. Hence the quota for the general public is often limited and hence chances are that all may be able to earn benefits from IPOs.

4) Once the company is listed, it would have to conduct regular shareholder meetings and also declare its financial status (earnings, profits, losses etc) from time to time – may be every quarter or semi-annually or annually depending on the particular country's laws to which the company belongs to.

5) As the company will have to expose its internal financial information to the public, hence it could be used by rivals and make the market competition tough.

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