Sunday, February 17, 2008

Some FAQs About IPOs

Following are the links to some of the commonly asked questions that one may have about IPOs. Clicking on each question will take you to a page that will answer that question. To come back to this page, click on the back button on the top of the page or click on the 'Home' button below this post and it will bring you back here.
    1. What is an IPO?
    2. How is an IPO priced?
    3. What is Book Building?
    4. Why does a company want to 'go public'?
    5. What is underwriting?
    6. What is a red-herring prospectus?
    7. What is the procedure for issuing an IPO?
    8. How does one analyse IPOs?

How Does One Analyse IPOs?

It's hard enough to analyze the stock of an established company. An IPO company is even trickier to analyze since there won't be a lot of historical information. Your main source of data is the red herring prospectus, so make sure you examine this document carefully. Look for the usual information, but also pay special attention to the management team and how they plan to use the funds generated from the IPO.

And about the underwriters, too. Successful IPOs are typically supported by bigger brokerages that have the ability to promote a new issue well. Be more wary of smaller investment banks because they may be willing to underwrite any company.

It's important to understand that underwriters are salesmen. The whole underwriting process is intentionally hyped up to get as much attention as possible. Since IPOs only happen once for each company, they are often presented as "once in a lifetime" opportunities. Of course, some IPOs soar high and keep soaring. But many end up selling below their offering prices within the year. Don't buy a stock only because it's an IPO - do it because it's a good investment.

How is an IPO Priced?

Historically, IPOs, both globally and in India, have been underpriced. The effect of underpricing an IPO is to generate additional interest in the stock when it first becomes publicly traded. This can lead to significant gains for investors who have been allocated shares of the IPO at the offering price. However, underpricing an IPO results in "money left on the table"—lost capital that could have been raised for the company had the stock been offered at a higher price.

The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than what the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it may lose its marketability and hence even more of its value.

Investment banks, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company. The process of determining an optimal price usually involves the
underwriters ("syndicate") arranging share purchase commitments from lead institutional investors.

How is the issue price decided on?

A company that is planning an IPO appoints lead managers to help it decide on an appropriate price at which the shares should be issued. There are two ways in which the price of an IPO can be determined: either the company, with the help of its lead managers, fixes a price or the price is arrived at through the process of book building.

What is a Red-Herring Prospectus?

"Red Herring Prospectus" is a prospectus which does not have details of either price or number of shares being offered or the amount of issue. This means that in case the price is not disclosed, the number of shares and the upper and lower price bands are disclosed. On the other hand, an issuer can state the issue size and the number of shares are determined later. A Red-Herring Prospectus for an IPO can be filed with the RoC without the price band and the issuer, in such a case, will notify the floor price or a price band by way of an advertisement one day prior to the opening of the issue. In the case of book-built issues, it is a process of price discovery and the price cannot be determined until the bidding process is completed. Hence, such details are not shown in the Red Herring prospectus filed with the RoC in terms of the provisions of the Companies Act.
The reason it is called a red herring is due to a disclosure statement printed in red ink on the cover which explicitly states that the issuing company is not attempting to sell its shares till it is approved by the regulator.

Why Does a Company Want to 'Go Public'?

When a company lists its shares on a public exchange, it will almost invariably look to issue additional new shares in order to raise extra capital at the same time. The money paid by investors for the newly-issued shares goes directly to the company (in contrast to a later trade of shares on the exchange, where the money passes between investors). An IPO, therefore, allows a company to tap a wide pool of stock market investors to provide it with large volumes of capital for future growth. The company is never required to repay the capital, but instead the new shareholders have a right to future profits distributed by the company.

The existing shareholders will see their shareholdings diluted as a proportion of the company's shares. However, they hope that the capital investment will make their shareholdings more valuable in absolute terms.

In addition, once a company is listed, it will be able to issue further shares via a
rights issue, thereby again providing itself with capital for expansion without incurring any debt. This regular ability to raise large amounts of capital from the general market, rather than having to seek and negotiate with individual investors, is a key incentive for many companies seeking to list.

What is the Procedure for Issuing an IPO?

When a company wants to go public, the first thing it does is hire an investment bank, which does the underwriting. Underwriting is the process of raising money by either debt or equity (in this case we are referring to equity). You can think of underwriters as middlemen between companies and the investing public. The biggest underwriters are Goldman Sachs, Merrill Lynch, Credit Suisse First Boston, Lehman Brothers and Morgan Stanley.
The company and the investment bank will first meet to negotiate the deal. Items usually discussed include the amount of money a company will raise, the type of securities to be issued and all the details in the underwriting agreement. The deal can be structured in a variety of ways. For example, in a firm commitment, the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. In a best efforts agreement, however, the underwriter sells securities for the company but doesn't guarantee the amount raised. Also, investment banks are hesitant to shoulder all the risk of an offering. Instead, they form a syndicate of underwriters. One underwriter leads the syndicate and the others sell a part of the issue.
Once all sides agree to a deal, the investment bank puts together an offer document to be filed with the SEBI. This document contains information about the offering as well as company info such as financial statements, management background, any legal problems, where the money is to be used and insider holdings. The SEBI then requires a cooling off period, in which they investigate and make sure all material information has been disclosed. Once the SEBI approves the offering, a date (the effective date) is set when the stock will be offered to the public.

Source: Investopedia

What is Book Building

Book building is basically the process of generating a book of investor demand for an IPO for efficient price discovery. It is a mechanism where, during the fixed period for which the IPO is open, bids are collected from investors at various prices, between the floor price and the cap price. The final issue price is not determined until the end of the process when the book has 'closed'.

Book building is a common practice in most developed countries and has recently been making inroads into developing countries as well, including
India.

What is Underwriting

1. The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt).
2. The process of issuing insurance policies.

The word "underwriter" is said to have come from the practice of having each risk-taker write his or her name under the total amount of risk that he or she was willing to accept at a specified premium. In a way, this is still true today, as new issues are usually brought to market by an underwriting syndicate in which each firm takes the responsibility (and risk) of selling its specific allotment.

What is an IPO

An IPO stands for Initial Public Offering. The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market. Also referred to as a "public offering".

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

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