Personal Finance

What are the different types of IPO?5 min read

February 2, 2021 4 min read

What are the different types of IPO?5 min read

Reading Time: 4 minutes

An Initial Public Offering, or IPO, is the process by which a private company raises funds for its growth by selling its stocks to the public on stock markets. If the company grows at a stable pace, you, as an investor, your investment will grow along with the company. To ensure investor protection the entire IPO process is regulated by the Securities and Exchange Board of India (SEBI).

There are two ways through which companies can go public – through a fixed price offering or a book building offering or a company can also opt for a combination of both.

Fixed Price Offering

Under the fixed price offering, the company decides a fixed price at which the shares will be offered to investors. Thus, the company hires a merchant banker, an entity who is paid to evaluate and deduce the company’s level of risk. The merchant banker weighs the company’s assets and liabilities, i.e., the current value of the company and its future prospects. They also make a case about the risk overview of the investment and how it would compensate the investors in the face of such a risk. After comprehensive research, they determine what price should be fixed for each share to raise enough capital.

In this type of IPO, the investors know the share price before the company goes public. They pay the entire fixed price when subscribing to the IPO. What’s more, the demand for the securities is known only after the issue is closed.

Let’s take an example to understand the fixed price offering better.

For instance, a ventilator manufacturing company, Lifeline, that has been in the business for the last ten years and decides to expand its manufacturing plants by raising capital. There are two ways in which a company can raise capital, either through debt financing, i.e., borrowing money and paying back the lender at a later day, or through equity financing, i.e., by selling shares of the company’s stock, which is the IPO route. Companies may use a combination of these to raise capital, too. Lifeline’s promoters, however, decide to come up with an IPO by taking the fixed price offering route.

They approach their merchant banker who values the company by considering Lifeline’s assets, future projects, goodwill and promoter’s stake, on the one hand, and its liabilities, on the other hand. Subsequently, Lifeline files an application with SEBI to raise capital through the IPO route. Along with the filing, they are asked to provide documents that SEBI will need for vetting the IPO. This includes the Draft Red Herring Prospectus (DRHP). The DRHP gives an overview about the company’s business, its financials, its promoters, its reason for raising money and the risks associated with the business. Since the company’s documents are compliant with SEBI’s guidelines, Lifeline gets the green signal for the IPO.

Meanwhile, after careful consideration, the company and the merchant banker decide the price for the share. The face value, i.e., the actual value of the stock, would be Rs. 10, while the price at which it will be offered to the public is decided to be at Rs. 50. Next, Lifeline’s shares are open to the public for subscription.

As an investor, you may consider the DRHP, assess the company’s business, the track record, and exposure of the promoters, and the firm’s future prospects and decide if you want to apply for the IPO.

Book Building Offering

When an IPO is routed through the book-building process, the price of the IPO is not fixed by the company. Investors interested in buying the shares have to bid within a stipulated time before the price is decided. However, the bidding is done within a price band or range of 20%, which is set by the company. The lowest price in the range is the “floor price,” while the highest price in the range is the “cap price.”

The company also needs to specify how many shares it wishes to sell. The final price depends on the bids the company receives from the investors.

In this type of IPO, investors pay for the shares after the allocation is made. Let us understand the book building offering with an example.

A home décor company Adorn decides to raise capital for business expansion by making the company public. Of course, they hire a merchant banker who analyzes the company’s future prospects and its net worth, among other things to evaluate what range would be suitable for the company, i.e., how much investors would be willing to pay for a share.

Adorn has decided to issue 10,000 shares in its IPO. After a thorough analysis by the merchant banker, the price band is decided to be in the Rs. 100-Rs. 110 range. Investors interested in buying the shares of Adorn are requested to send in their bids within a predetermined time period. The bids received by investors are above or equal to the floor price, i.e., Rs. 100.

Bids for 3,000 shares are received at Rs. 100, for 6,000 shares at Rs. 105 and for 4,000 shares at Rs. 110.

After the bid window is closed, the final price, i.e., the cut-off price depends on the number of bids received at each price. In Adorn’s case, to issue all 10,000 shares, the minimum price will be Rs. 105, because bids for 6,000 and 4,000 shares (which adds up to 10,000 shares) were received at or above Rs. 105. The company will refund money to those who bid at Rs. 100, and it will refund the balance amount to those who bid at Rs. 110.

As the book is consistently built, you come to know how the demand for Adorn’s share is on a day-to-day basis.

Conclusion

There are some key differences between the two types of IPOs, i.e., the fixed price offering and the book building offering, with respect to the pricing, demand, and payment. Until 1999, IPOs in India were offered only via the fixed-price mechanism. Globally, the book-building process is more favoured as investors receive the shares at a fair price with a potential upside and the issuing company receives fair compensation for selling their stock.