What is Initial Public Offering (IPO)?

When a company wants to raise money from the public, it does so by approaching investors in the primary market. The process of raising money by issuing new securities to the investors in the primary market is known as Initial Public Offering. Once the security has been issued, investors can trade these securities (buy and sell) in the secondary market. In this article we will understand the process of initial public offering.

To raise money through an IPO, the issuer is required to approach an investment bank that helps them in selling these securities to the public. Together with the investment bank, the issuer will come out with a prospectus for the offering, which will contain many details about the offer, the company, the risks involved, the purpose of funds, growth prospects and so on.

Once the offering is ready, the investment bank will campaign for the IPO and approach investors to subscribe to the offer. This process is called the book building process. For this reason, the investment banker is also sometimes called the book runner. In the book building process the investment bank also plays an advisory role and helps its investors to make wise investment choices.

There are two types of offerings, namely, underwritten offering and best efforts offering. Between the two, the underwritten offering is the most common way of raising money.

Underwritten Offering

In an underwritten offering, the investment bank acts as the underwriter for the offering. The issuer and the bank will mutually decide the best price at which the offer should be made. After that the bank is committed to sell the entire offer at the specified price. If the issue is oversubscribed, then the securities may be allocated to clients on a preferred or pro-rata basis. However, if the issue is undersubscribed, then the investment bank will have to buy the securities that it is unable to sell to the public. Along with this commitment, the investment bank also promises to be the market maker for a month in the secondary market. This ensures liquidity and price support for the new offer. For an underwritten offer, the bank charges an underwriting fee of about 7% to the issuer. If it’s a very large issue, then a syndicate of many investment banks, with one of them as the lead underwriter, will do the booking building.

Best Efforts Offering

In case of a best efforts offering, the investment bank does not have any commitment to fully subscribe the offer. The bank will make its best effort to reach the highest subscription, but in case the offer is undersubscribed, the issuer will have to accept whatever is sold.

Setting the right price for the issue is crucial. If the price set is seen as very high by the investors, then the issue will be undersubscribed, and the investment bank will have to buy shares itself to fill the offer. This is an unfavourable scenario for the investment bank. On the other hand, if the price set is low, then the issue will be oversubscribed, and securities are allocated on a preferred or pro-rata basis. Due to these factors, the IPO prices generally get lowered. This also explains why we see sudden price rise when the stock starts trading in the secondary markets. The issuers are also generally okay with a slightly lower price because they want to avoid an undersubscribed offering which is seen as unfavourable prospects for the business.