Is Investing in an IPO a Right Choice?

Investing your money in IPO can give you attractive returns, however there is also a risk of losing money. Before investing in IPOs, you should understand what are IPOs, how they are different from investing in stocks and what are the risks in investing in the IPO. Let us find the answer of these questions in this post.

What is an IPO?

The full form of IPO is initial public offering. When a company sells its shares first time directly to the public then it is call an IPO. Now the question is why the companies sell their shares to the public. Let us understand this.

When a startup or the company which is in business form a long time grows in size then to keep pace of growth and to further expand the companies across other cities or countries or to tap other national or international markets, the company needs funds. This fund may be obtained either in the form of loan or equity. If the company decides to take loan, then there may be a cost of capital which the company has to pay and may be such huge capital is not available through loan. In this case the company arrange the funds by selling its shares to the public directly. Public buy the shares of the company and give money to the company which is utilized by the company to further expand or to run its day to day operations.

The companies issue and IPO to raise capital by selling its private shares to public or institutions, to pay off debt, to fuel growth initiatives or to diversify the business of the company across other domains.

When a company decides to go public, it chooses a lead underwriter to help the company with the securities registration process and distribution of shares to the public.  The lead underwriter then assembles a group of investment banks and broker dealers (a group known as a syndicate) that is responsible for selling shares of the IPO to institutional and individual investors.

Types of IPOs

Generally, there are two types of IPOs.

Fixed Price Issues

In this type of issue, the price of the shares is evaluated by the company itself with the help of its underwriters. The underwriters evaluate the company’s financial standing, assets, liabilities, etc., and fix the price of offerings on the basis of these data. The price is fixed by examining all the qualitative as well as quantitative aspects of the company. In this type of issue, the price may be undervalued during the company’s IPO. The price is usually kept lower than the market value of the offering. This is the reason that investors are mostly interested in fixed price issues and ultimately revalue the company positively.

Book Building Issue

This is relatively new concept in India. In this type of issue, there are no fixed price of the offerings. The company gives a price band or range and you can bid for the shares for the desired price you would like to pay. The lowest price is called the floor price and the highest price is called the cap price. The price of the stock is fixed after evaluation the bids. The demand of the share is known after each day as the book is built.

The IPO can be done by any of the above methods or as a combination of two.

Difference Between Fixed Price Issue and Book Building Issue

Should You Invest in IPOs?

Investing in IPO can be profitable but you should not get swept away in hype. Do not invest in an IPO just because others are also investing. Many start- ups and young companies debut with very high expectations and become out of business after a short duration. Investment in IPOs, therefore may become risky. The investors should make their due diligence by carefully analyzing the profile of the company. This task may be challenging because of lack of readily available public information about a new company. However, the investor may review the issuing company’s preliminary prospectus, also known as ‘red herring’. This prospectus which is prepared by the issuer and the lead underwriter, contains important information about the company like information about the management, target market, the company’s financials, who is holding the shares of the company, expected price range, potential risks, number of shares, etc. Careful examination of all these data can help the investor in making investment decisions for the IPO.

Participating in an IPO

Before participating in an IPO, you should be aware about the eligibility criteria for participation. You can participate in an IPO through your stock broker if your brokerage firm offers access to the new offerings. Usually, high net worth investors of experience traders are eligible for participation in an IPO. Individual investors may face difficulty in obtaining shares in an IPO because the demand often exceeds the number of shares available. Due to high demand and scarcity of shares, many brokerage firms limit who can participate in the offerings.

It is also important to understand that if you sell your shares within the first several days of trading, may firms may restrict your eligibility to participate in the future offerings. The practice of quickly selling IPO shares is known as “flipping,” and it is something most brokerage firms discourage.

Conclusion

Investing in IPOs may be rewarding because they provide investors an opportunity to invest in the company relatively early in the life cycle and the investor may reap the fruits when the company flourish after some time. This is the reason that many investors are willing to invest in IPOs. However, investing in IPOs without proper analysis and due diligence may be risky. Therefore, you should make your own analysis before investing in an IPO and should not get swept away in hype.

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