Understanding IPOs: Why Companies Go Public and Key Terms Every Investor Should Know

As an investor, you’ve likely heard the buzz around Initial Public Offerings (IPOs) whenever a company announces its plans to go public. IPOs are a significant event in the financial world, offering investors a chance to own a piece of a company. But what exactly is an IPO, What drives companies to launch IPOs, and what terms should you understand to make smart investment decisions?

What is an IPO and Why Do Companies Go Public?
An Initial Public Offering (IPO) is the process through which a private company offers its shares to the public for the first time, becoming a publicly traded company listed on a stock exchange like the BSE (Bombay Stock Exchange) or NSE (National Stock Exchange) in India. By doing so, the company raises capital from public investors, and its shares can be traded freely in the stock market.

Why Do Companies Choose to Launch an IPO?

• Raising Capital: The primary reason companies go public is to raise funds. The money collected from an IPO can be used for various purposes, such as expanding operations, paying off debts, funding research and development, or entering new markets. For example, a company like Zomato used its IPO proceeds to fuel growth and innovation.

• Liquidity for Existing Shareholders: IPOs allow early investors, founders, or promoters to sell their shares, providing them with liquidity. This is often seen in companies where venture capitalists or private equity investors want to exit their investments.

• Brand Visibility and Credibility: Going public increases a company’s visibility and brand recognition. Being listed on a stock exchange also enhances credibility, making it easier to attract customers, partners, and talent.

• Access to Future Capital: Public companies can raise additional funds in the future through follow-on offerings (like FPOs – Follow-on Public Offerings) or debt instruments, as they have an established market presence.

• Employee Incentives: IPOs allow companies to offer stock options or equity-based compensation to employees, helping attract and retain talent. For instance, startups like Paytm have used this strategy to reward employees.

However, going public also comes with challenges, such as increased regulatory scrutiny, the need to disclose financials publicly, and pressure to deliver consistent results to shareholders. Despite these, IPOs remain a popular choice for companies looking to scale up.


12 Key IPO Terms Every Investor Should Know-

To navigate the IPO process confidently, you need to understand the terminology. Below, we explain 12 essential IPO terms in a way that’s clear for Indian investors, along with a few additional points to enhance your understanding.

1. DRHP (Draft Red Herring Prospectus)
The DRHP is a preliminary document filed by the company with the Securities and Exchange Board of India (SEBI) before launching an IPO. It contains detailed information about the company’s financials, business model, risks, and plans for the IPO proceeds. It’s called a “red herring” because it’s not final and may undergo changes. Investors should read the DRHP to understand the company’s fundamentals before investing. For example, the DRHP of LIC’s IPO provided insights into its massive asset base and market dominance.

2. Underwriters
Underwriters are financial institutions (like investment banks) hired by the company to manage the IPO process. They assess the company’s value, structure the IPO, and ensure shares are sold to investors. If the IPO doesn’t attract enough buyers, underwriters may buy the unsold shares themselves. In India, firms like Kotak Mahindra Capital and ICICI Securities often act as underwriters.

3. Greenshoe Option
Also known as an “over-allotment option,” the greenshoe option allows underwriters to issue additional shares (up to 15% of the original issue size) if the IPO is oversubscribed. This helps stabilize the share price post-listing by meeting excess demand. For example, if a company offers 1 crore shares and demand is high, the greenshoe option allows the sale of an additional 15 lakh shares.

4. Anchor Investors
Anchor investors are institutional investors (like mutual funds or insurance companies) who are allotted shares before the IPO opens to the public. Their participation signals confidence in the IPO, boosting retail investor interest. In India, anchor investors are allotted shares at a fixed price and are subject to a lock-in period (typically 30 days). For instance, anchor investors in Nykaa’s IPO included global funds like BlackRock.

5. Bid Lot
A bid lot is the minimum number of shares an investor must apply for in an IPO. It’s set by the company to streamline the allocation process. For example, if the bid lot is 50 shares and the IPO price is ₹300, you need to apply for at least 50 shares (₹15,000). Investors can apply for multiple lots but not fractional lots.

6. Grey Market
The grey market is an unofficial market where IPO shares are traded before they are officially listed on the stock exchange. The Grey Market Premium (GMP) indicates the premium at which shares are trading in this market, giving investors a sense of expected listing price. For example, if an IPO’s issue price is ₹100 and the GMP is ₹20, the shares may list at around ₹120. However, grey market trends are speculative and not always accurate.

7. Fixed Price vs. Book Building
IPOs can be offered through two methods:

• Fixed Price: The company sets a specific price for the shares, and investors apply at that price. This is less common in India.

• Book Building: The company offers a price range (price band), and investors bid within that range. The final price is determined based on demand. Most Indian IPOs, like those of Paytm or Zomato, use the book-building process, as it allows better price discovery.

  
  

8. Floor Price and Issue Price

• Floor Price: The lowest price in the price band set for a book-building IPO. For example, if the price band is ₹100–₹120, ₹100 is the floor price.

• Issue Price: The final price at which shares are allotted to investors after the bidding process. It’s determined based on the demand and bids received within the price band.

  
  

9. Cut-Off Price
In a book-building IPO, retail investors can bid at the “cut-off price,” which means they agree to buy shares at the final issue price determined by the company. This is a safe option for retail investors, as it ensures they get shares at the price finalized after considering all bids.

10. Oversubscribed and Undersubscribed

• Oversubscribed: When the demand for IPO shares exceeds the number of shares offered. For example, if a company offers 1 crore shares but receives applications for 3 crore shares, the IPO is oversubscribed. In such cases, shares are allotted proportionately, often through a lottery for retail investors.

• Undersubscribed: When the demand is less than the shares offered. This may lead to the IPO being canceled or the underwriters stepping in to buy the remaining shares.
  
  

11. Price Band
The price band is the range within which investors can bid for shares in a book-building IPO. For example, a company might set a price band of ₹500–₹550 per share. Investors can bid at any price within this range, and the final issue price is determined based on the bids received.

12. Lock-in Period
Certain shareholders, like promoters or anchor investors, are restricted from selling their shares for a specific period after the IPO, known as the lock-in period. In India, this is typically 30 days for anchor investors and up to 3 years for promoters. This ensures stability in the stock price post-listing.

Additional Points to Understand IPOs Better

• Retail Investor Category: In India, SEBI reserves a portion of IPO shares (usually 35%) for retail individual investors (RIIs), who apply for shares worth up to ₹2 lakh. This ensures small investors get a fair chance to participate.

• Application Supported by Blocked Amount (ASBA): When applying for an IPO, the application amount is blocked in your bank account via ASBA. The money is debited only if you’re allotted shares, ensuring your funds remain safe during the process.

• Listing Gains: Many investors participate in IPOs hoping for listing gains, where the share price rises above the issue price on the listing day. However, not all IPOs deliver listing gains, as seen in cases like Paytm’s IPO, which listed below its issue price.

• Risks of IPO Investing: IPOs can be risky due to limited historical data, market volatility, and overvaluation. Always research the company’s financials, industry trends, and management before investing.

• Role of SEBI: SEBI regulates IPOs in India, ensuring transparency and protecting investors. It reviews the DRHP and monitors the IPO process to prevent malpractices.
  
  

Tips for Investors

• Read the DRHP: It’s your best source for understanding the company’s business, financial health, and risks.

• Avoid Herd Mentality: Don’t invest just because an IPO is hyped. Evaluate its fundamentals and your investment goals.

• Check the GMP: While not foolproof, the grey market premium can give you an idea of market sentiment.

• Use ASBA: Apply through ASBA to ensure your funds are safe and the process is seamless.

• Diversify: Don’t put all your money into one IPO. Spread your investments to manage risk.
  
  

Conclusion

IPOs are an exciting way for Indian investors to participate in a company’s growth, but they require careful research and understanding. Knowing terms like DRHP, greenshoe option, and price band empowers you to make informed choices. Whether you’re eyeing the next big IPO or just starting out, always analyze the company’s fundamentals, read the DRHP, and align your investments with your financial goals. With SEBI’s oversight and tools like ASBA, India’s IPO market is accessible, but success lies in staying informed and cautious.

Happy investing, and may your IPO journey be rewarding!

Disclaimer: IPO investments carry risks, including market volatility and potential losses. Always conduct thorough research or consult a financial advisor before investing.