Module 1   Introduction to Stock MarketsChapter 5

The IPO Markets – Part 2

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5.1 – Overview

The previous chapter gave us an understanding of how a company evolved right from the idea generation stage to all the way until it decides to file for an IPO. The idea behind creating the fictional story in the previous chapter was to give you a sense of how a business matures over time. The emphasis obviously was on the different stages of business and funding options available at various stages of business. The previous chapter gives you a perspective of what a company would have gone through before it comes out to the public to offer its shares.

This is extremely important to know because the IPO market, also called the Primary market sometimes attracts companies offering their shares to the public without actually going through a healthy round of funding in the past. A few rounds of funding by credible VC and PE firms validate the quality of the business and its promoters. Of course, you need to treat this with a pinch of salt but nevertheless it acts as an indicator to identify well run companies.

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5.2 – Why do companies go public?

We closed the previous chapter with a few critical questions. One of which – Why did the company decide to file for an IPO, and in general why do companies go public?

When a company decides to file for an IPO, invariably the main reason is to raise funds to fuel their CAPEX requirement. The promoter has 3 advantages by taking his company public:

  1.  He is raising  funds to meet CAPEX requirement
  2. He is avoiding the need to raise debt which means he does not have to pay finance charges which translates to better profitability
  3. Whenever you buy a share of a company, you are in essence taking the same amount of risk as the promoter is taking. Needless to say, the proportion of the risk and its impact will depend on the number of shares you hold. Nonetheless, whether you like it or not, when you buy shares you also buy risk. So when the company goes public, the promoter is actually spreading his risk amongst a large group of people.

There are other advantages as well in going for an IPO…

  1. Provide an exit for early investors – Once the company goes public, the shares of the company start trading publicly. Any existing shareholder of the company – could be promoters, angel investors, venture capitalists, PE funds; can use this opportunity to sell their shares in the open market. By selling their shares, they get an exit on their initial investment in the company. They can also choose to sell their shares in smaller chunks if they wish.
  2. Reward employees –Employees working for the company would have shares allotted to them as an incentive. This sort of arrangement between the employee and the company is called the “Employee Stock Option”. The shares are allotted at a discount to the employees. Once the company goes public, the employees stand a chance to see capital appreciation in the shares. Few examples where the employee benefited from ESOP would be Google, Infosys, Twitter, Facebook, etc
  3. Improve visibility – Going public definitely increases visibility as the company has a status of being publicly held and traded. There is a greater chance of people’s interest in the company, consequently creating a positive impact on its growth.

So let’s just build on our fictional business story from the previous chapter a little further and figure out the IPO details of this company.

If you recollect, the company requires 200 Crs to fund their CAPEX and the management had decided to fund this partly by internal accrual and partly by filing for an IPO.

Do recollect that the company still has 16% of authorized capital translating to 800,000 shares which are not allotted. The last valuation of these shares when the PE firm invested in Series B was 64Crs. The company has progressed really well ever since the PE firm has invested and naturally the valuation of these shares would have gone up.

For the sake of simplicity, let us assume the company is now valuing the 16% shares anywhere between 125 Crs to 150 Crs. This translates to a per-share value, anywhere between Rs.1562 to Rs.1875/-…(125Crs/8lakh).

So if the company puts 16% on the block to the public, they are likely to raise anywhere between 125 to 150 Crs. The remainder has to come from internal accruals. So naturally, the more money they raise, the better it is for the company.

5.3 – Merchant Bankers

Having decided to go public, the company must now do a series of things to ensure a successful initial public offering. The first and foremost step would be to appoint a merchant banker. Merchant bankers are also called Book Running Lead Managers (BRLM)/Lead Manager (LM). The job of a merchant banker is to assist the company with various aspects of the IPO process including:

  • Conduct due diligence on the company filing for an IPO, ensure their legal compliance and also issue a due diligence certificate
  • Should work closely with the company and prepare their listing documents including Draft Red Herring Prospectus (DRHP). We will discuss this in a bit more detail at a later stage
  • Underwrite shares – By underwriting shares, merchant bankers essentially agree to buy all or part of the IPO shares and resell the same to the public
  • Help the company arrive at the price band for the IPO. A price band is the lower and upper limit of the share price within which the company will go public. In the case of our example, the price band will be Rs.1562/- and Rs.1875/-
  • Help the company with the roadshows – This is like a promotional/marketing activity for the company’s IPO
  • Appointment of other intermediaries namely, registrars, bankers, advertising agencies, etc. The Lead manager also makes various marketing strategies for the issue

Once the company partners with the merchant banker, they will work towards taking the company public.

5.4 – IPO sequence of events

Needless to say, each and every step involved in the IPO sequence has to happen under the SEBI guidelines. In general, the following are the sequence of steps involved.

  • Appoint a merchant banker. In case of a large public issue, the company can appoint more than 1 merchant banker
  • Apply to SEBI with a registration statement – The registration statement contains details on what the company does, why the company plans to go public and the financial health of the company
  • Getting a nod from SEBI – Once SEBI receives the registration statement, SEBI takes a call on whether to issue a go-ahead or a ‘no go’ to the IPO
  • DRHP – If the company gets the initial SEBI nod, then the company needs to prepare the DRHP. A DRHP is a document that gets circulated to the public. Along with a lot of information, DRHP should contain the following details:
      1. The estimated size of the IPO
      2. The estimated number of shares being offered to the public
      3. Why the company wants to go public and how does the company plan to utilize the funds along with the timeline projection of fund utilization
      4. Business description including the revenue model, expenditure details
      5. Complete financial statements
      6. Management Discussion and Analysis – how the company perceives future business operations to emerge
      7. Risks involved in the business
      8. Management details and their background
  • Market the IPO – This would involve TV and print advertisements in order to build awareness about the company and its IPO offering. This process is also called the IPO roadshow
  • Fix the price band – Decide the price band between which the company would like to go public. Of course, this can’t be way off the general perception. If it is, then the public will not subscribe for the IPO
  • Book Building – Once the roadshow is done and the price band fixed the company now has to officially open the window during which the public can subscribe for shares. For example, if the price band is between Rs.100 and Rs.120, then the public can actually choose a price they think is fair enough for the IPO issue. The process of collecting all these price points along with the respective quantities is called Book Building. Book building is perceived as an effective price discovery method
  • Closure – After the book building window is closed (generally open for few days) then the price point at which the issue gets listed is decided. This price point is usually the price at which maximum bids have been received.
  • Listing Day – This is the day when the company actually gets listed on the stock exchange. The listing price is the price decided based on market demand and supply on that day and the stock is listed at a premium, par or discount of the cut-off price

5.5 – What happens after the IPO?

During the bidding process (also called the date of issue) investors can bid for shares at a particular price within the specified price band.  This whole system around the date of the issue where one bids for shares, is referred to as the Primary Market. The moment the stock gets listed and debuts on the stock exchange, the stock starts to trade publicly. This is called the secondary market.

Once the stock transitions from primary markets to secondary markets, the stock gets traded daily on the stock exchange. People start buying and selling stocks regularly.

Why do people trade? Why does the stock price fluctuate? Well, we will answer all these questions and more in the subsequent chapters.

5.6 – Few key IPO jargons

Before we wrap up the chapter on IPO’s let us review a few important IPO jargons.

glossaryUnder subscription – Let’s say the company wants to offer 100,000 shares to the public. During the book-building process, it is discovered that only 90,000 bids were received, then the issue is said to be under subscribed. This is not a great situation to be in as it indicates negative public sentiment

glossary Oversubscription – If there are 200,000 bids for 100,000 shares on offer then the issue is said to be oversubscribed 2 times (2x)

glossary Green Shoe OptionPart of the underwriting agreement which allows the issuer to authorize additional shares (typically 15 percent) to be distributed in the event of oversubscription. This is also called the overallotment option

glossary Fixed Price IPOSometimes the companies fix the price of the IPO and do not opt for a price band. Such issues are called fixed price IPO

glossary Price Band and Cut off pricePrice band is a price range between which the stock gets listed. For example, if the price band is between Rs.100 and Rs.130, then the issue can list within the range. Let’s says it gets listed at 125, then 125 is called the cut off price.

5.6 – Recent IPO’s in India*

Here is a look at a few recent IPO’s in India. With all the background information you now have, reading this table should be easy.

 

Sl No Name of Issue Issue Price (INR) BRLM Date of Issue Issue Size (Lakh Shares) Price Band (INR)
01 Wonderla Holidays Limited 125 Edelweiss Financial Services and ICICI Securities Limited 21/04/2014 to 23/04/2014 14,500,000 115 to 125
02 Power Grid Corporation of India Ltd 90 SBI, Citi, ICICI, Kotak, UBS 03/12/2013 to 06/12/2013 787,053,309 85 to 90
03 Just Dial Ltd 530 Citi, Morgan Stanley 20/05/2013 to 22/05/2013 17,493,458 470 to 543
04 Repco Homes Finance Limited 172 SBI, IDFC, JM Financials 13/03/2013 to 15/03/2013 1,57,20,262 165 to 172
05 V-Mart Retail Ltd 210 Anand Rathi 01/02/2013 to 05/02/2013 4,496,000 195 to 215

                                                                                                                       *Source : NSE India, as of June 2014


Key takeaways from this chapter

    1. Companies go public to raise funds, provide an exit for early investors, reward employees and gain visibility
    2. Merchant banker acts as a key partner with the company during the IPO process
    3. SEBI regulates the  IPO market and has the  final word on whether a company can go public or not
    4. As an investor in the IPO, you should read through the DRHP to know everything about the company
    5. Most of the IPOs in India follow a book-building process

513 comments

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  1. Praveen says:

    How do underwriters sell there shares? Do they sell in normal market through stock exchange/bulk deal/private placement/offer for sale?

  2. AastroGuru says:

    Karthik,
    Never seen any such educational content clear and lucid.
    Could you add a fictional case of IPO, about prices of book building issue price, bid price range, price discovery, listing price in secondary market?
    I am getting confused with Book Building and issue.
    The content may be clear but the problem could be with me.
    For Eg, an IPO in primary market is set a range for 100-120, for retailers to bid.
    Assume Many people bid 120.
    Then will the issue price will be 120, what will be listing price in the secondary market, will it be same or different?

    • Karthik Rangappa says:

      That is a good idea, maybe we will create additional chapter detailing this.

      In the example you have suggested, bidders will have to bid for a price between 100 to 120…and lets say the price gets fixed to 118. 118 will be the issue price.

      • AastroGuru says:

        Yeah got it, but when it gets listed in the second market, what price it will get listed.
        Example, I bought IPO of 10000 qty (already issued to me), then at what price this will get listed on NSE, on listing day?
        Is it same as 118.

        • Karthik Rangappa says:

          The listing price will depend on how people perceive the stock. For example in the recent Snowman Logistic IPO, the issue price was fixed around 45 but once it debuted on the exchange the price went up all the way to 75.

          • AastroGuru says:

            Oh you mean the opening price on listing day is 75 because market sentiment was good. Cool!

          • akrsrivastava says:

            So you mean that the first tick on the price can be different from 45?

          • Karthik Rangappa says:

            Absolutely!

          • Prashant Agarwal says:

            Karthik – I am still confused pertaining if the issue price in case of the snowman was decided at 45 than how did it jump to 75 at the 1st tick.

            As the normal investor is not allowed to invest at that time. So, is this fluctuation is being conducted by PE firm or Merchant Bankers?

          • Karthik Rangappa says:

            45 was the issued price, but the demand was so much that people were ready to pay a higher price on the day of listing, hence the price increased. Once the stock hits the exchange, anyone can buy or sell the stock.

      • suman says:

        i hav to say ZERODHA/VERSITY is the BEST simple,learning,useful,interactive stuff i come across ever.
        the moto of ZERODHA …….”ZERO RUDDH”…is nice

        i hav 2 qustions
        1st, is the “primary market” bidding through live system(as we see in TRADING TERMINAL) where everyone can see bidding price, bidding quantity,etc? or it just goes offline where we can`t see those?

        2nd, above you mentioned a average amount “bidders will have to bid for a price between 100 to 120…and lets say the price gets fixed to 118. 118 will be the issue price.”…….how this 118(issued price) fixed? how it fix?….is it like…..30no. share @ 115, 40 no.shr @110, 10no. [email protected] 118 after issue the company getes it as a average………or……..within book binding process the rate is fixed…..or any other process?

        • Karthik Rangappa says:

          Good to know you like the content here 🙂

          1) NSE updates this information, check this – http://www.nseindia.com/products/content/equities/ipos/ipo_current_precam.htm?cat=A

          2) The rates are fixed based on the book building process, where in the price point which attracts the maximum amounts of bids is considered for the bidding price.

          • Akshay Ajay says:

            Say if the Maximum bids were received at a stock price of 118, then is it like only those people will be issued stocks on the listing day.

            What happens to the people who had placed the bids at 115 or say 122 like that….

            Will the person who placed a bit at 122 be issued the stocks at 118 value and 115 be rejected?

          • Karthik Rangappa says:

            Yes, listing price is at maximum bids. 122 will get it at 118, but 115 will be rejected. Hence, for this reason, its always best to bid at the highest price.

    • Laxman says:

      Yes, I agree. The way Karthik explains is very clear an simple that layman can understand very easily and take interest to read further.
      Thank you friend Karthik.

    • Laxman says:

      Yes, I agree. The way Karthik explains is a very clear and simple, that layman person like me can also understand very easily and develops interest to read it further.
      Thank you very much Karthik, for such a nice articles .

  3. akrsrivastava says:

    How does an increase or decrease in share price of a company impact the company. Suppose XYZ listed at 100/- The company received 100/- from its each of its new shareholders and proceeded to invest this into its business. Does the future increase or decrease in the price affect in any way, the functioning of the company? If price rises to 120/- in the secondary market, this does not imply that there will be a further inflow of 20/- per share into the company. Hope I made my question clear. The company’s reputation may be at stake, but what apart from that?

    • Karthik Rangappa says:

      After the issue, the increase and decrease of prices do not matter much to the company. Hence there is no additional inflow to the company. However do remember, the promoter (also the business owner) is also a shareholder of the company. If the share price increase/decrease his personal net worth increases/decreases.

      • Akshay Ajay says:

        When the VCs were investing in the coming the valutations were based on the price they were paying for the certain percentage of the equity in the company. Now once the company is publicaly traded if the promoter shareholding will vary based on the stock market price, will the valuations done during funding stage not be valid??

        • Karthik Rangappa says:

          The shareholding will not change…what will change is just the stock price and therefore the valuation. No, once the stock is listed, there is no official valuation of the stock. In fact, the valuation is supposed to happen in the market, which is also called the ‘price discovery’, by the markets.

  4. kashish shambhwani says:

    i have a doubt in book building segment
    say price band is 100-110..now i want to apply for the shares,then at what price should i apply?

  5. adithyau says:

    Nice explanation .

    Can you please also explain how share are allocated if its over subscribed . Some say they distribute such that atleast one lot we will get and hence its always better to apply just for one lot in case of popular stocks

    And also can you please explain about the price protection if some company offers like 15% price protection . How it works

    • Venu Madhav says:

      Yes, in the recent times SEBI did make such amendements mandating that all issuing companies shall ensure that each retail participant gets a minimum bid lot irrespective of his application size. However this is subject to the availablity of shares.

      So this means, that if the issue is a popular one which is most likely to get oversubscribed, its best to apply for just one lot rather than for multiple lots because the odds of getting allotment of more than the minimum lot is really low.

      This was done with the intention to encourage participation from investors who stay away from IPO’s thinking they won’t get allotment any shares.However the downside to it was those who apply for the full amount are likely to get fewer shares.

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