IPO Meaning

Initial Public Offering (IPO) can be defined as the process in which a private company or
corporation can become public by selling a portion of its stake to the investors. An IPO is
generally initiated to infuse the new equity capital to the firm, to facilitate easy trading of
the existing assets, to raise capital for the future or to monetize the investments made by
existing stakeholders.

Types of IPO
There are two common types of IPO. They are:

Fixed Price Offering

Fixed Price IPO can be referred to as the issue price that some companies set for the initial
sale of their shares. The investors come to know about the price of the stocks that the
company decides to make public.
The demand for the stocks in the market can be known once the issue is closed. If the
investors partake in this IPO, they must ensure that they pay the full price of the shares
when making the application.

Book Building Offering

In the case of book building, the company initiating an IPO offers a 20% price band on the
stocks to the investors. The interested investors bid on the shares before the final price is
decided. Here, the investors need to specify the number of shares they intend to buy and
the amount they are willing to pay per share.

The lowest share price is referred to as floor price and the highest stock price is known as
cap price. The ultimate decision regarding the price of the shares is determined by
investors’ bids.

Terms Associated with IPO

To have informed knowledge about IPO, it is necessary that one comes to know about
some basic terms used in the process. Some of the commonly used terms are:

Issuer
An issuer can be referred to as the company or the firm who wants to issue shares in the
secondary market in order to finance its operations.

Underwriter
An underwriter can be a banker, financial institution, merchant banker or a broker. It
assists the company to underwrite their stocks. The underwriters also commit that they will
subscribe to the balance shares in case the stocks offered at IPO are not picked by the
investors.

Draft Red Herring Prospectus

The DRHP is the document that makes the public know about the company’s IPO listings
after the approval made by SEBI. A DRHP contains the following information about the
company:

 Purpose of raising funds through listings

 Balance sheet

 Promoter’s expenses

 Earning statement of the last three years (if applicable)

 Net proceeds of the company

 Commission and discounts of the underwriter

 Details such as the name and address of all the underwriters, officers, directors
and stockholder who possess 10% or more than the currently outstanding stock.

 Legal opinion on the listings

 Copy of the underwriting document

Fixed Price IPO and Price Band

Fixed Price IPO can be referred to as the issue price that some companies set for the initial
sale of their shares.

A price band can be defined as a value-setting method where a seller offers an upper and
lower cost limit, the range within which the interested buyers can place their bids. The
range of the price band guides the buyers.
Under subscription and oversubscription
Under subscription takes place when the number of securities applied for is less than the
number of shares made available to the public.

Oversubscription is the condition when the number of shares offered to the public is less
than the number of shares applied for.

Book Building
The process by which an underwriter or a merchant banker tries to determine the price at
which the IPO will be offered is called book building. A book is made by the underwriter
where he submits the bids made by the institutional investors and fund managers for the
number of shares and the price they are willing to pay.

Once an idea has been made and the price band is decided, the underwriter or the merchant
banker decides the IPO price. The issuer company’s shares are open for subscription for
three trading days.

Why does a company file for an IPO?

There are several advantages of a company choosing to change its status from a privately-
held to a public-listed company.

#To raise funds from a wider pool of investors

#Facilitate mergers & acquisitions

#Gain visibility

#Provide an exit for early investors

Steps in IPO process in India

#1 Hire an investment bank (lead manager)

Once a company decides that it wants to go public, it needs to hire investment banks which
are market intermediaries recognized by regulators. The selection of investment banks is a
function of several factors like their industry expertise and reputation, distribution capabilities
and prior relationship with the company, if any.

The mandate for investment banks is to find the best valuation of the company and get
investors to buy the IPO. To ensure the success of IPOs, investment banks are required to
underwrite the issue, either themselves or through a third party for a fee. After going through
the company’s financial statements, industry dynamics and risk appetite among investors,
investment banks advise their clients on the IPO.

For regular IPOs, no single investment bank would like to assume the full risk and thus, they
usually form a syndicate which includes other merchant banks. The bank leading the pack is
known as lead manager.

#2 Prepare draft prospectus and submit with SEBI

When all the three parties (issuing company, investment bank, underwriter) agree on the
broad contours of the IPO, they need to prepare a draft prospectus and submit the same with
SEBI. The draft red herring prospectus (DRHP) is a document covering extensive details
about the company’s business so far, its plans for the future and the competitive scenario in
its industry. The draft prospectus also outlines how the company is planning to use the funds
generated from IPO.

The regulator’s job is to vet the DRHP filed by the company and it may ask follow-up
questions as well as demand more disclosures to be made. Once the regulator is satisfied with
the information provided by the company, it issues “observation” which is another way of
saying that the IPO has got regulatory approval.

#3 Road shows (‘dog and pony’ shows)

Now that the issue has been approved by the regulator, company management and lead
managers travel extensively across the country to market the IPO to potential investors which
are mostly institutional investors. Generally 50% shares in mainboard IPOs are reserved for
qualified institutional investors (QIBs), making these investors critical to ensure success of
the IPO.
This road show phase lasts for at least couple of weeks and may take longer if more investors
are required to be roped in due to size or attractiveness of the issue. In Indian context, road
shows may start even before the IPO is approved by the regulator.

It is important to highlight that this is an integral step in IPO process in India as the book-
building system we follow in IPOs ensures allotment at same price to everyone.

#4 IPO Process: RHP and Pricing

When the company files draft prospectus, it is not required to disclose how the issue will be
priced and when it will be launched. Once the issue gets regulatory approvals and the
company is ready to launch the IPO, it files an updated version of the prospectus.

This version is called red herring prospectus (RHP). An RHP contains updated financial
information as well as the dates of the IPO. However, this document is also devoid of issue
pricing. An IPO’s price band, discount to retail investors and employees and the minimum
bid lot size are decided couple of days before the IPO.

#5 IPO Process in India: Bidding through book-building

After finalizing pricing, the IPO is made available to investors for bidding. For mainboard
IPOs, it is usually a price range while for smaller issues it is a fixed price band. Typically,
IPOs are kept open for at least 3 working days and it can be extended in case of
undersubscription. An IPO can be kept open for a maximum of 10 days.

The IPO bidding framework in India allows online as well as offline applications for public
offers. Nevertheless, efforts are underway by SEBI to reduce offline applications.

#6 IPO Allotment

Upon completion of IPO bidding, allotment is the next important step and the responsibility
of this phase is with the issue registrar. Even in the case of a successful IPO, there are
different possibilities and accordingly, the number of shares allotted may be different. Here is
more on the logic behind IPO allotment.

Since stock trading is mandatorily in demat form in India, the registrar has to ensure credit of
shares in the respective demat accounts of successful applicants.

#7 Listing and lock-in periods

In India, the IPO process culminates in the form of listing of the company on stock exchange.
With the listing in the secondary market, successful applicants can sell their shares on stock
exchanges and new investors can purchase. However, certain shareholders such as anchor
investors and promoters are subject to lock-in periods which means they cannot sell their
shares immediately after listing.

Anchor investors are subject to a lock-in period of 30 days from the date of allotment.   The
lock-in is more stringent for promoters. According to SEBI regulations, 20% of the
company’s fully diluted post-offer equity share capital held by promoters is locked-in for a
period of three years from the date of allotment.

What is ‘IPO Grading’?

IPO grading is the grade assigned by a Credit Rating Agency (CRAs) registered with SEBI,
to the initial public offering (IPO) of equity shares or any other security which may be
converted into or exchanged with equity shares at a later date. The grade represents a relative
assessment of the fundamentals of that issue in relation to the other listed equity securities in
India.
Such grading is generally assigned on a five‐point scale with a higher score indicating
stronger fundamentals and vice versa as below. IPO grade 1 ‐ Poor fundamentals IPO grade 2
‐ Below‐Average fundamentals IPO grade 3 ‐ Average fundamentals IPO grade 4 ‐ Above‐
average fundamentals IPO grade 5 ‐ Strong fundamentals IPO grading has been introduced as
an endeavour to make additional information available for the investors in order to facilitate
their assessment of fundamentals of the company offering equity issues through an IPO.

1. I am an issuer. By when am I required to obtain the grade for the IPO?

IPO grading can be done either before filing the draft offer documents with SEBI or
thereafter. However, the Prospectus/Red Herring Prospectus, as the case may be, must
contain the grade/s given to the IPO by all CRAs approached by the company for grading
such IPO.

2. Who bears the cost of the IPO grading process?

The company desirous of making the IPO is required to bear the expenses incurred for
grading an IPO.
3. Is grading optional?
Yes, IPO grading is optional. It was mandatory previously. However, with effect from
February 04, 2014 IPO grading has been made optional for the issuer.

4. Can the issuer reject an IPO grade?

IPO grade/s cannot be rejected. Irrespective of whether the issuer finds the grade given by the
rating agency acceptable or not, the grade has to be disclosed as required under the ICDR
Regulations. However the issuer has the option of opting for another grading by a different
agency. In such an event all grades obtained for the IPO will have to be disclosed in the offer
documents, advertisements etc.

5. Will IPO grading delay the process of issue?

IPO grading is intended to run parallel to the filing of offer document with SEBI and the
consequent issuance of observations. Since issuance of observation by SEBI and the grading
process, function independently, IPO grading is not expected to delay the issue process.

6. What are the factors that are evaluated to assess the fundamentals of the issue while
arriving at the IPO grade?
The IPO grading process is expected to take into account the prospects of the industry in
which the company operates, the competitive strengths of the company that would allow it to
address the risks inherent in the business and capitalize on the opportunities available, as well
as the company’s financial position.
While the actual factors considered for grading may not be identical or limited to the
following, the areas listed below are generally looked into by the rating agencies, while
arriving at an IPO grade:
a. Business Prospects and Competitive Position i. Industry Prospects ii. Company Prospects
b. Financial Position
c. Management Quality
d. Corporate Governance Practices
e. Compliance and Litigation History
f. New Projects—Risks and Prospects It may be noted that the above is only indicative of
some of the factors considered in the IPO grading process and may vary on a case to case
basis.

7. Does IPO grading consider the price at which the shares are offered in the issue?
No. IPO grading is done without taking into account the price at which the security is offered
in the IPO. Since IPO grading does not consider the issue price, the investor needs to make an
independent judgment regarding the price at which to bid for/subscribe to the shares offered
through the IPO.

8. Where can I find the grades obtained for the IPO and details of the grading process?
All grades obtained for the IPO along with a description of the grades can be found in the
Prospectus, Abridged Prospectus, issue advertisement or any other place where the issuer
company is making advertisement for its issue. Further the Grading letter of the Credit Rating
Agency which contains the detailed rationale for assigning the particular grade will be
included among the Material Documents available for Inspection at the registered office of
the Company.

9. Does an IPO grade, which indicates ‘above average or strong fundamentals’ mean I
could subscribe safely to the issue?
An IPO grade is NOT a suggestion or recommendation as to whether one should subscribe to
the IPO or not. IPO grade needs to be read together with the disclosures made in the
prospectus including the risk factors as well as the price at which the shares are offered in the
issue.

10. How do I interpret the IPO Grades?

The grades are allocated on a 5‐point scale, the lowest being Grade 1 and highest Grade 5.

11. How does IPO Grading help in deciding about investing in an IPO?
IPO Grading is intended to provide the investor with an informed and objective opinion
expressed by a professional rating agency after analyzing factors like business and financial
prospects, management quality and corporate governance practices, etc. However,
irrespective of the grade obtained by the issuer, the investor needs to make his/her own
independent decision regarding investing in any issue after studying the contents of the
prospectus including risk factors carefully.

12. What is the role of SEBI in IPO grading exercise?

SEBI does not play any role in the assessment made by the grading agency. The grading is
intended to be an independent and unbiased opinion of that agency.

13. Will IPO Grading given by CRAs be a parameter for SEBI to issue its observations?
The grading is intended to be an independent and unbiased opinion of a rating agency. SEBI
does not pass any judgment on the quality of the issuer company. SEBI’s observations on the
IPO document are entirely independent of the IPO grading process or the grades received by
the company.