What is an IPO?

Primary market is the place where new offerings by companies are made as an Initial Public Offering (IPO). IPOs are offerings made by the company for the first time. Such an offer to the public can be at par or at a premium. The pricing of the issue depends upon the current status of the company and the company is allowed to fix a justifiable issue price. 

We all know why money is so important for a new business and how issuing a share, i.e selling part of their company to equity holders in the form of shares, can change the business prospects of the companies. 

Let us look at the whole process with an example to understand how stocks are issued.

We know that almost every large corporation had a humble beginning and gradually became financial giants. Infosys is one such example. It was established by Narayana Murthy and six engineers in Pune in 1981 with a small initial capital. But look at Infosys today. It is a NASDAQ-listed global consulting and IT services’ company with more than 1, 00,000 employees. From that small initial capital the company has grown to become a USD 4 billion company.

When a company is growing, the biggest hurdle it faces is raising enough money to expand. So owners generally have two options. They can either borrow the required money from a bank or sell a part of the business to investors and use the money to fund growth. To understand how issuing stock works in a better way, let’s look at a fictional company called XYZ Furniture. After getting married, a young couple decides to start a business on their own. It would allow them to work for themselves, as well as arrange their hours around their family. This is a natural decision for any person with an entrepreneurial mindset.

Both husband and wife have always had a strong interest in furniture and so they decide to open a store in their hometown. After borrowing money from the bank, they name their company XYZ Furniture and go into business. During the first few years the company makes a little profit. The earnings are, however, ploughed back into the store to buy additional inventory and make additions to the building to accommodate the increasing pace of business. 

Ten years later, the business has grown rapidly. The couple has managed to pay off the company’s debts, profits are over Rs 5, 00,000 a year. Convinced that XYZ Furniture could do as well in several larger, neighbouring cities, the couple decides that they want to open two new branches. They research their options and find out it is going to cost over Rs 40 lakh to expand. Not wanting to borrow money and be strapped with interest payments again, they decide to sell stock in the company. 

The company approaches an underwriter such as Goldman Sachs or J P Morgan, who determines the value of the business. As mentioned before, XYZ Furniture earns Rs 5, 00,000 after-tax profits each year. It also has a book value of Rs 30 lakh (the value of the land, building, inventory etc out of which is subtracted the company’s debt). The underwriter researches and discovers that the average furniture stock is trading at 20 times the earnings.

What does this mean? Simple, that you would multiply the earnings of Rs 5,00,000 by 20. In XYZ Furniture’s case, this works out to Rs 1 crore. Add the book value and you arrive at Rs 1.3 crore. This means, in the underwriter’s opinion, that ABC Furniture is worth Rs 1.3 crore. Our young couple, now in their 30s, must decide how much of the company they are willing to sell. Right now they own 100 per cent of the business. The more they sell, the more is the cash they will raise. However, they will also be giving up a large part of their ownership. As the company grows, that ownership will be worth more and so a wise entrepreneur would not sell more than he or she has to. 

After discussing the issue with the right people, the couple decides to keep 60 per cent of the company and sell the other 40 per cent to the public as stock. This means that they will keep Rs 78 lakh worth of the business. Because they own a majority of the stock, they will still be in control of the store. The other 40 per cent they sell to the public is worth Rs 52 lakh. The underwriters find investors who are willing to buy the stock and pay the couple Rs 52 lakh. 

Although they now own less of the company, their stake will hopefully grow faster since they have the means to expand rapidly. Using the money from their public offering, XYZ Furniture successfully opens two new stores and has Rs 12 lakh in cash left over. Business is even better in the new branches since they are in more populated cities. Each of the stores makes an annual profit of around Rs 8,00,000 while the old store still makes an average of Rs 5,00,000. Between the three stores, XYZ now makes an annual profit of Rs 21 lakhs.
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This is great news because although they don’t have the freedom to do business the way want to the business is now valued at Rs 5.1 crore (multiply the new earnings of Rs 21 lakh per year by 20 and add the book value of Rs 90 lakh since there are three stores now instead of one). The couple’s 60 per cent stake is worth Rs 3.6 crore. With this example it is easy to see how small businesses seem to explode in value when they go public. The original owners of the company become, in a sense, wealthier overnight.

Earlier, the amount they could take out of the business was limited to the profit. Now, they are free to sell their shares in the company at any time and thus raise cash quickly. This process is the basis of the functioning of Dalal Street. The stock market is, at its core, a large auction where ownership in companies like XYZ Furniture is sold to the highest bidder each day. When we buy the shares of XYZ later from BSE or NSE then it is termed as the secondary market.

Therefore, primary market provides opportunity to issuers of securities; Government as well as corporate, to raise resources to meet their financial requirements. They may issue the securities at face value or at a discount/premium.

Face value is the stated amount (in Rs.) assigned to a security by the issuer. In a case of shares, it is the original cost of the stock shown on the certificate; for bonds, it is the amount paid to the holder at maturity. It is also known as par value or simply par.

When a security is sold above its face value, it is said to be issued at a Premium and if it is sold at less than its face value, then it is said to be issued at a Discount and these securities may take a variety of forms such as equity, debt etc. They may issue the securities in domestic market and/or international market.

A public issue refers to issue of securities like equity shares or bonds and debentures but let us mainly focus on equity shares. 

• Initial Public Offer (IPO).
• Follow-On Public Offer (FPO) or Seasoned Issue.

Initial Public Offer (IPO)

Simply put, an IPO is a company’s first sale of stock/shares to the public. The investing public is usually excited about an IPO. It is hard to understand why since most stocks that are sold during an IPO tend to perform badly at the initial stages. Some companies also do not survive. So investing in an IPO is also risky and usually less rewarding than investing in more established stocks. Perhaps investors believe the sales hype that usually accompanies an IPO. Perhaps they are excited about being among the first to own the next potential IBM or Microsoft.

IPOs can be a risky investment. For the individual investor, it is tough to predict what the stock or share will do on its initial day of trading and in the near future since there is often little historical data with which to analyse the company. Also, most IPOs are of companies going through a transitory growth period, and they are therefore subject to additional uncertainty regarding their future value.

Some IPOs do very well right from the start, and it is these IPOs that are remembered. The IPOs that fail are quickly forgotten, while stories of successful IPOs are re-told and their returns frequently exaggerated. However, the active involvement of SEBI and others in protecting the interests of investors has helped to reduce the risk factor to a certain level. Reliance Power was listed on the stock market after its IPO and its share value went down by 21 per cent and closed at Rs 373.5 on the BSE as compared to its issue price of Rs 430 for the retailers. 

Follow-On Public Offering

When a company is not listed to trade on any stock exchange and offers to the public its shares for the first time with a view to getting listed, it is known as a first time issue. It is listed after the IPO is complete and shares allotted. A follow-on public offering is made by listed companies for raising additional funds. The shares of such companies could be bought either from the stock market or in the public offer.