Every Investor wants to invest in an IPO. But what exactly is an IPO, how does it work. what are the pros and cons of an IPO.
Let’s try to understand it. In this post, I’d explain the IPO and clear up some misunderstandings along the way.
Mechanism Behind IPO
An initial public offering, or IPO, is the very first sale of stock issued by a company to the public. Prior to an IPO the company is considered private, with a relatively small number of shareholders made up primarily of early investors.
In IPO Promoter/Owner sell some portions of their company to public who can buy or sell share at stock exchange upon listing. This is why an IPO is also referred to as “going public.”
Why Companies go for an IPO
There are two main reasons behind it –
- To raise capital
When a company require funds for its business, it has a option of going to financial institutions like banks for funds in form of loans. But you have to pay interest on loans. So to avoid the burden of debts promoters decide to go public to carry out their capital requirements.
In an IPO, some portion of shares held by promoters and other early investors are issues to the public which reduces the stakes of existing shareholders. So in a way IPO provides a route for early investors to sell their holding. Alternatively company can also issue new shares in the IPO. In this case the holding percentage of the existing investors adjusts according to the quantity of shares issued.
Tip – If early investors are not selling large quantity of their shares then it’s a great sign to invest in such companies.
- To improve brand recognition of the company
Going public means company comes under the lens of regulation and it increases governance of the company. In financial world, business builds on reputation and because you are under the scrutiny of Stock Regulator it helps you to build a reputation. This Brand recognition increases the company’s exposure, prestige, and public image, which can help the company’s sales and profits. This also helps to get debt at lower interest rate and company attracts better & skilled employees.
Public listed companies have to publish quarterly financial reports and annual reports that enhances transparency between company owners and public.
Draft Red hearing prospectus (DRHP) is one of the most important tools to analyze the IPO. A Draft Red Herring Prospectus, or offer document, is when a company that is planning to raise money from the public provides detailed information about its business operations and financials.
This includes details about its promoters, the reason for raising money, how the money will be used, risks involved with investing in the company and so on. Investors should bear in mind that it does not provide information about the price or size of the offering.
Investors can access a company’s DRHP on various platforms — the company website, the merchant banker website, stock exchange websites or the SEBI website. Announcements are also made in newspapers in multiple languages as per the rules.
Pros & Cons of an IPO
There are several benefits of going public:
1. The firm can raise capital to finance its growth opportunities at lower rate.
2. It gains access to a public equity pool that can be tapped in the future.
3. An IPO gives venture capitalists a chance to realize a return on their investment, gives an opportunity to sell some of their shares.
4. Becoming a public company enhances the liquidity of the firm’s shares.
5. Public firms can use their shares as currency in future acquisitions.
6. The fact that a firm exposes itself to public scrutiny can be interpreted as a commitment by management to perform well.
7. The visibility that comes along with a successful IPO can increase the firm’s brand value and act as a marketing tool.
Disadvantages associated with an IPO:
1. Increases costs as going public is a costly process
2. Imposes more restrictions on management
3. Forces disclosure to the public
4. Makes former business owners lose control of decision making.
5. Sometimes cunning promoters keeps the issuing price unreasonably high
6. Significant legal, accounting and marketing costs
7. Increased time, effort and attention required of management for reporting