Why Should You Not Invest In An IPO? – Kuvera

Primary and Secondary Market

 

Before we dive deep into the working structure of an Initial Public Offering (IPO), let’s first understand what primary and secondary markets are. The capital market represents the “Primary Market” and the “Secondary Market”. Both are the two interrelated and inseparable components of the capital market. The capital market is a marketplace for the trade of debt and equity instruments and their derivatives-like options. In this market, financial instruments comprising both equity and debt are issued and traded. This also includes private placement sources of debt and equity as well as organized markets like stock exchanges. The capital market can be further divided into primary and secondary markets. In the primary market, securities are offered to the public for subscription for the purpose of raising capital or funds. A secondary market is an equity trading avenue in which already existing/pre-issued securities are traded amongst investors.

 

 

What Is An IPO?

 

An IPO means an Initial Public Offering. It is the process by which a privately owned company becomes a publicly traded company by selling its shares to the public. The sale of securities to the general public on the primary market is known as an Initial Public Offering (IPO). 

 

An IPO is a crucial stage in a company’s development. It allows a company to obtain funds through the public capital market. An IPO also significantly boosts a company’s reputation and media exposure. An IPO is frequently the sole option for financing significant growth and advancement. 

 

A company may have very few stockholders before an IPO. Founders, angel investors, and venture capitalists are a few examples. An IPO is when a company offers its shares to the general public. You can acquire shares directly from the company to join as a shareholder. Through the IPO process, companies can raise equity capital by issuing new shares to the public.

 

How Is The IPO Allotment Process Executed?

 

• Appointment of investment bankers/underwriters

The company initially searches for underwriters or investment banks to begin the IPO process in India. Mostly, companies prefer to take services from more than one investment bank. The company’s management team will review the company’s assets, liabilities, and financial situation before formulating a plan to meet its financial requirements. The underwriters act as intermediaries between the corporation and its investors. The underwriting agreement will then be signed and will include the following:

 

• • Details of the agreement

• • Funds needed to raise for the issue

• • Details of the securities to be issued

 

• IPO Registration

An IPO, or initial public offering, is the process by which a privately held company, or a company owned by the government, raises funds by offering shares to the public or to new investors. Following the IPO, the company is listed on the stock exchange.

 

While coming up with an IPO, the company has to file its offer document with the market regulator, the Securities and Exchange Board of India (SEBI).

 

The company submits a draft prospectus, which is required by the Companies Act. It’s also referred to as a “Red Herring Prospectus” (RHP). All required disclosures required by the Securities and Exchange Board of India (SEBI) and the Companies Act are included in this prospectus. The essential elements of RHP are as follows:

 

• • Definitions: It includes a glossary of terminology used in the industry.

• • Risk factors: They list the possibilities that could have an effect on the company’s finances.

• • Use of proceeds: This portion of the prospectus is perhaps the most significant. This informs the investors of the intended use of the funds raised through the IPO. 

• • Industrial & Business Description: This section describes how the company operates within the specific industry sector. For instance, if the business is in the consumer sector, this section will offer estimates and forecasts for that industry. The primary business operations of the company are described in this section.

• • Management: Information on important management figures is provided in this section.

• • Financial Description: The auditor’s report and financial statements are presented in this part.

• • Legal and Other Information: This section lists the legal actions taken against the company as well as any other information that may be necessary.

 

• SEBI validation

SEBI then confirms whether the company disclosed all relevant information or not. As soon as the application is approved, the company can reveal the date of its IPO. However, approval from SEBI does not guarantee that the facts/data represented in the offer document are correct or not. 

 

•  Application to the stock exchange

The company must send an application to the stock exchange in order to sell its first stock.

 

• The IPO frenzy

The corporation wants to generate excitement in the market before an IPO opens for public subscription. Before the IPO officially opens on the stock exchange, it will be promoted by firm leaders who will promote the impending IPO around the nation. In order to draw new investors, it uses marketing and promotional strategies. They also use different methods that are easy to understand, such as Q&A sessions, group meetings, multimedia presentations, online virtual roadshows, and more.

 

• Choosing an Initial Public Offering Price

 An Initial Public Offer (IPO) is the sale of securities to the public in the primary market. There are two types of public issues: either a fixed-price IPO or a book-binding offer. In a fixed-price issue, investors are informed in advance of the price at which shares will be sold and allotted. Whereas, in a book-building issue, the issuer offers a 20% range within which investors can bid for the shares. The final price is decided only after the bidding has closed. 

 

During the bidding process, bidders must also submit their offers according to the company’s lot pricing.  The offer document will have details of the book building process, including lot size, maximum bids allowed, etc., which tells them how many shares they need to buy at least.

 

The company also offers the IPO floor price, which is the lowest bid price, and the IPO cap price, which is the highest bid price, respectively. The IPO subscription period typically lasts for three to five business days. Investors can therefore take advantage of the option to apply for the IPO through authorized banks and brokerage firms. The price at which the issue is finally sold is called the “cut-off price.”

 

• Allocation Procedure

The underwriters and stakeholders determine how many shares each investor will receive after the company sets the IPO price. Unless IPOs are oversubscribed, investors typically receive all securities. Their Demat account receives credit for the shares. The company’s IPO will begin trading on the stock market once the securities have been allotted. 

 

What Is The Purpose Of An Initial Public Offering?

An initial public offering (IPO) is the first time that shares of a company are made available to the general public. For a variety of reasons, companies seek an IPO to raise capital. Whatever the reason, the overall objective of an IPO is to raise the company to new heights and boost its profitability.

 

• To raise capital: Companies frequently choose to go public to raise capital for their businesses. Raising capital can be done for a variety of reasons, including expanding a firm, paying off debt, developing infrastructure, etc. The goal is to accumulate some money to aid in future advancements. The possibility of company expansion increases with capital.

 

• Liquidity for existing shareholders: Some shareholders would like to cash out their investments after making financial contributions to the company. The best strategy for monetizing the shareholding is to go public. The majority shareholders, such as private equity funds or the government, can sell their stake in the company by participating in a public offering. 

 

• It gives visibility and credibility: A few companies’ operations are made more open by going public. For instance, financial information, managerial alterations, etc. All publicly traded companies are governed by SEBI rules and regulations. Additionally, it guarantees regular reporting of all the data. Consequently, a company’s trustworthiness frequently increases after going public.

 

• Improves financial situation: A company’s shares can be sold to the general public to generate significant liquidity and capital that can be used to enhance the company’s future. As a result, the business will be in a stronger financial position to make a loan request or negotiate loan terms.

 

Why Should You Avoid IPOs Despite The Market Hype?

The safest and best way to invest is thought to be through initial public offerings (IPOs). This isn’t always the case, though. IPOs frequently fall short of the pre-launch promises they made. IPOs are regularly exaggerated. Here are a few reasons why you should not invest in IPOs:

 

• Unpredictable allotment: The allotment in IPOs is unpredictable. There is no assurance that investors will receive their shares, which is one of the biggest risks of participating in the IPO.

 

• Time-consuming Process: You must conduct thorough research on the company and its prior performance before investing in an IPO. Although it is available in the company’s prospectus, understanding it requires effort and time.

 

• The price of IPOs is a mystery: A stock’s IPO price is decided after consulting with one or more investment banks. These investment banks are employed by and compensated by the firm that is going public. The offer price should ideally be based on the company’s valuation, which is determined by projecting the company’s financial future. Individual investors who don’t know what the company has planned for the future can’t tell if this value is realistic and a good indicator of how the company will grow in the future. Sometimes companies value themselves too much and listing their stock crashes.

 

• External factors like grey markets and market mood matter: Shares are offered through private placements even before the public offering is available for IPO subscription. There is a “grey market,” or active trade based on the over-the-counter price of these shares, dependent on the listing prospects of a stock. Although grey market pricing is merely indicative, it does point to the general direction of IPO subscription demand. If there is a lot of demand, there is a good likelihood that the listing price will trade at a premium.

 

• Investment in a secondary market (IPO in the stock market): Investors can always choose to wait for the listing to take place and give it 6 to 9 months, by which time 2-3 quarters of earnings would have been released and analysts would have begun in-depth coverage of the company. Investors will learn more about the financial health of the company as well as how management makes decisions and talks to shareholders.

 

You must also be conscious of the risks involved and the fact that not every IPO will result in profits if you are investing in them out of peer pressure or a fear of missing out. 

 

FAQ’s

 

• What are the risk factors in an IPO document?

You must conduct thorough research on the company and its prior performance before investing in an IPO. Although it is available in the company’s prospectus, understanding it requires effort and time. Here are a few points an investor should check out in a real draft red herring prospectus:

• Company Information: This section discusses a company’s primary functions and business practices.

 

• Financial information: The financial report will give you as an investor a general sense of potential dividend payments depending on the profits stated. Using the financial statement, you can figure out how safe and profitable your next investment will be.

 

• Risk factors: Under the heading “Risk Factors,” businesses outline the potential dangers that could affect their operations and business. While many concerns are often stated, some need more examination. For instance, it could be a smart idea to steer clear of the IPO if you discover that the company has several open legal disputes. You should be able to read between the lines as an investor to discover the true risks that can endanger the company’s future growth.

 

• Use of Proceeds: A company may launch an IPO for a number of reasons. Learn what the business plans to do with the money it receives from the IPO. 

 

• Sector overview: The standing of the company in relation to its rivals is disclosed in a “red herring” prospectus. The document also includes performance trends for the sector to which the organization belongs. If you’re looking forward to a company’s initial public offering (IPO), you should look into the many business and economic factors at play, the way supply, and demand work, and the company’s future prospects.

 

• Management: The future prospects of a corporation are greatly influenced by its management.  Information on directors, promoters, and other key management employees, including names, qualifications, and titles, can be found in this section. It might also contain details about any criminal prosecutions, financial delinquencies, or ongoing legal actions against these individuals. Because each of them could be a risk factor, it is crucial to review this section.

 

• Is investing in an IPO risky?

Key IPO risks to know while investing:

 

No assurance that you’ll get the shares: It must be taken into consideration that the biggest risk involved in applying for an IPO is that you may not be allotted the shares. There is no assurance of returns in terms of shares or any other type of allocation, so it might very well be viewed as an offering procedure.

 

Getting a lower price than the offered rate: When you buy Pre-IPO shares, you run the risk of receiving less than you invested.

 

External influences can affect the price: The price of a stock going public is set in consultation with one or more investment banks.  These investment banks are employed by and paid by the company that is going public. The offer price should ideally be based on the company’s valuation, which is determined by projecting the company’s financial future. Whether this valuation is reasonable and an accurate representation of the future growth of the company is hard to judge for individual investors who are unaware of its future plans

 

• Can you lose money in an IPO?

Yes, one can suffer losses while you plan for an IPO investment anytime. When you purchase Pre-IPO shares, there is a chance that you will get back less money than you put in. This is due to the fact that the actual price of Pre-IPO shares is only established after they are listed, and there are numerous instances when the stated price of the share ends up being less than the purchase price. If this happens with the company you chose, you will lose the money you put down as a deposit.

 

• Why Avoid IPOs?

An IPO investment does appear glamorous and is interesting to discuss. But if you are unaware of the realities, it might be challenging. The four reasons why you should avoid IPOs are :

• No guarantee of getting the shares.
• Getting a lower price than the expected price: When you buy Pre-IPO shares, you run the risk of receiving less than you invested.
• External influences can affect the price: Many external factors like the over-valuation of shares by the issuer company or sudden market crash can impact the price of stocks.

 

Interested in how we think about the markets?

 

Read more: Zen And The Art Of Investing

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