A corporate may raise capital in the primary market by way of an initial public offer, rights issue or private placement. An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. It is the largest source of funds with long or indefinite maturity for the company. Requirement of funds in order to finance the business activities motivates small entrepreneurs to approach the new issue market. Initial Public Offer (IPO) is a route for a company to raise capital from investors to meet the expenses for its projects and to get a global exposure by listed in the Stock Exchange. Company raising money through IPO is also called as company ‘going public’. From an investor’s point of view, IPO gives a chance to buy shares of a company, directly from the company at the price of their choice.
Initial Public Offering (IPO) Process
First the firm has to select an underwriter for selling its securities in primary market. The company usually consults with an investment banker to determine how best to structure the offering and how it should be distributed. Since most of the new issues are too large for one underwriter to effectively manage, the investment banker, also known as the underwriting manager, invites other investment bankers to participate in a joint distribution of the offering. The group of investment bankers is known as the syndicate. Members of the syndicate usually make a firm commitment to distribute a certain percentage of the entire offering and are held financially responsible for any unsold portions. The underwriter syndicate can choose either best effort method or firm commitment method for selling of the securities.
There exist two main mechanisms in India for the sale of public issues.
1. Fixed Price Method
In a fixed priced offer, an issuer company is allowed to freely price the issue. The basis of issue Price is disclosed in the offer document where the issuer is closes in detail about the qualitative and quantitative factors justifying the issue price. The issuing firm (with the help of the underwriter) decides upon a selling price and offers a set number of shares at that price. The underwriter does not build a book of potential orders; instead, the price is based upon the underwriter’s judgment of the market conditions and the intrinsic value of the company. The Issuer company can mention a price band of 20% (cap in price band should not be more than 20% of the floor price) in the Draft offer documents filed with SEBI and actual price can be determined at a later date before filing of the final offer document with SEBI / ROCs. In its offering materials, the issuer will give both a qualitative and quantitative justification for the chosen price. If the offering is oversubscribed, the shares are allocated on a pro rata basis. This type of offering is commonly used in Singapore, Finland, India and the U.K.
2. Book Building Process
In the traditional IPO process, an investment bank is always hired to “underwrite” an IPO. The issuing firm will choose a “lead underwriter” (book runner) or “co managers” risk, the investment banks themselves almost always form a syndicate, and each member of which will sell part of the issue. Deals can be structured in a variety of ways. One major consideration is whether it is a “firm commitment” or “best efforts” agreement. In a firm commitment, the underwriter buys the entire offer and resells it to the public, thus guaranteeing the amount of money that will be raised; under a best efforts agreement the underwriter sells as much of the security to the public as it can sell at the offering price, but it does not guarantee the quantity. Underwriting contracts will also specify he underwriter fee (typically 5%) and the “green shoe” option (allows the underwriter to increase the number of shares offered, typically by 15%).
After the details of the deal have been worked out, the underwriter files a registration statement with the SEBI. This document provides details on the offering, as well as company information, such as financial statements, management backgrounds, legal proceedings, and insider holdings. Next, the underwriter puts together a “red herring” (a preliminary prospectus that contains information on the company and offering), and goes on a “road show” in which they present to potential investors and gauge demand. Most of these potential investors are institutional investors, such as mutual funds, pension funds, and hedge funds, and they give the underwriter feedback as to how much stock they intend to buy and at what price. This is called the “book building process” since the underwriter builds a book of potential orders. After the SEBI approves the registration and the road show is complete, the underwriter and issuing firm decide on an offering price range, which will depend upon the success of the road show, the current market conditions, and the company’s goals. After the offering range is decided upon, the underwriter will accept bids from interested investors.
If the orders exceed the value of the issuance, the IPO is “oversubscribed.” When this is the case, the offering will price at the high end of (or even a little above) the offering range, the underwriter will have partial discretion over how to allocate the limited shares among the bidding institutional investors, and the underwriter will exercise its green shoe option. When an offering is undersubscribed, it will price at the low end of the range; or, if the offering is extremely undersubscribed, the issuer may decide to postpone the deal. Since institutional investors are their best clients, investment banks heavily favor them over retail (individual) investors. Thus, there is a degree to which retail investors are “excluded” from IPO’s.
This is compounded by the fact that in many IPO’s, only those individual investors who have a brokerage account with one of the underwriters are even eligible to participate in the offering. The defining features of the book building mechanism are: a price that is elastic to demand but ultimately set by the underwriter, and a discretionary share allocation mechanism that has historically led to the exclusion of most retail investors. This method is used in almost all domestic IPO’s.