Initial Public Offering (IPO)

INITIAL PUBLIC OFFERING (IPO)

INITIAL PUBLIC OFFERING (IPO) is when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuer’s securities.

THREE DIFFERENT MECHANISMS FOR AN IPO

The decision to list a company is often taken considering the market trends. When the primary markets are strong, there is a natural temptation to take a company public. This is because, in a strong market, the company gets much more than its fair valuation. The equation gets reversed when the secondary markets are caught in a bear phase and this has a cascading effect on the primary markets.

An IPO is needed for a company to sell its stock to the general public for the 1st time and get a listing on the stock exchange (a necessary precondition to the trading of securities on an exchange). Companies normally come out with IPOs when they need fresh capital for expansion plans. Private equity investors, many a times, also use IPO as an exit route from the company.

Globally, there are three different mechanisms for completing an IPO —

1. Auctions

2. Fixed Price Offerings

3. Book Building

(1) Auctions

In an auction, the shares are offered for sale, on a predetermined schedule, to several competing potential buyers. IPO auctions are quite similar to auctioning on eBay. In an auction at eBay, the winning bidder is the one who offers the highest price, and the price is whatever that person’s final bid is. There are two types of auctions used for an IPO – ‘Single Price Auction’ and ‘Dutch Auction’. In a Single price auction (uniform price auction), all winning bidders pay the lowest price regardless of the prices they bid. In a Dutch auction (discriminatory auction), winning bidders pay the amount they bid. IPO auctions have been tried in many countries—Italy, the Netherlands, Portugal, Sweden, Switzerland, and the United Kingdom in the 1980s and Argentina, Malaysia, Singapore, Taiwan and Turkey in the 1990s. But they were abandoned years before book building became popular. IPO auctions were most robust in France, being used alongside both fixedprice public offers and a restricted form of book building for many years. Even in France, however, IPO auctions were abandoned once standard book building/ public offer simultaneous hybrids were allowed.

(2) Fixed Price Offering

Under a fixedprice offering, a certain number of shares are offered to retail investors at a preset price, which is generally identical to the price offered to institutional investors. Any Interested investor indicates to his bank the number of shares he wishes to purchase at that price. This mechanism is rarely used now a day. However, in some countries, this method is used within the book building process. The process starts with a book building for institutional investors. The price is set and after that, there is a fixedprice offering for retail investors that typically last for five days. The private investors can buy the offered stock at the price of the book building. The trading starts only after the book building process gets completed.

(3) Book Building

Book building is the process whereby the bank marketing the IPO gets to know the price investors intend to offer and the volume of the security they are interested in. Book building mechanism allows the issuer company to make a public issue through the process of ‘price discovery’ rather than through a price that is fixed beforehand. Book Building process was rare outside North America in 1980s and early 1990s. However, these days approximately 90% of IPOs use book building method.

In India, under the SEBI provisions and ICDR Regulations, it is possible to make an IPO either in the form of 100% retail issue or via book building process.

IPO – FREQUENTLY ASKED QUESTIONS

v  What is a Follow on Public Offering?

      A follow on public offering (FPO) is when an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, through an offer document. An offer for sale in such scenario is allowed only if it is made to satisfy listing or continuous listing obligations.

v  What is a Rights Issue?

      Rights Issue (RI) is when a listed company which proposes to issue fresh securities to its existing shareholders as on a record date. The rights are normally offered in a particular ratio to the number of securities held prior to the issue. This route is best suited for companies who would like to raise capital without diluting stake of its existing shareholders unless they do not intend to subscribe to their entitlements.

v  What is a Preferential Issue?

      A preferential issue is an issue of shares or of convertible securities by listed companies to a select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights issue nor a public issue. This is a faster way for a company to raise equity capital. The issuer company has to comply with the Companies Act and the requirements contained in Chapter pertaining to preferential allotment in SEBI (DIP) guidelines which inter-alia include pricing, disclosures in notice etc.

v  What is SEBI’s Role in an Issue?

      Any company making a public issue or a listed company making a rights issue of value of more than Rs. 50 lakhs is required to file a draft offer document with SEBI for its observations. The company can proceed further on the issue only after getting observations from SEBI. The validity period of SEBI’s observation letter is three months only ie. the company has to open its issue within three months period.

v  Does it mean that SEBI recommends an issue?

      SEBI does not recommend any issue nor does take any responsibility either for the financial soundness of any scheme or the project for which the issue is proposed to be made or for the correctness of the statements made or opinions expressed in the offer document.

v  Does SEBI approve the contents of the issue?

      It is to be distinctly understood that submission of offer document to SEBI should not in any way be deemed or construed that the same has been cleared or approved by SEBI. The Lead manager certifies that the disclosures made in the offer document are generally adequate and are in conformity with SEBI guidelines for disclosures and investor protection in force for the time being. This requirement is to facilitate investors to take an informed decision for making investment in the proposed issue.

v  Does SEBI tag make my money safe?

      The investors should make an informed decision purely by themselves based on the contents disclosed in the offer documents. SEBI does not associate itself with any issue/issuer and should in no way be construed as a guarantee for the funds that the investor proposes to invest through the issue. However, the investors are generally advised to study all the material facts pertaining to the issue including the risk factors before considering any investment. They are strongly warned against any ‘tips’ or news through unofficial means.

v  What are Disclosures and Investor protection guidelines?

      The primary issuances are governed by SEBI in terms of SEBI (Disclosures and Investor protection) guidelines. SEBI framed its DIP guidelines in 1992. Many amendments have been carried out in the same in line with the market dynamics and requirements. In 2000, SEBI issued “Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000” which is compilation of all circulars organized in chapter forms. These guidelines and amendments thereon are issued by SEBI India under section 11 of the Securities and Exchange Board of India Act, 1992. SEBI (Disclosure and investor protection) guidelines 2000 are in short called DIP guidelines. It provides a comprehensive framework for issuances buy the companies.

v  How does SEBI ensure compliance with Disclosures and Investor protection?

      The Merchant Banker are the specialized intermediaries who are required to do due diligence and ensure that all the requirements of DIP are complied with while submitting the draft offer document to SEBI. Any non compliance on their part, attract penal action from SEBI, in terms of SEBI (Merchant Bankers) Regulations. The draft offer document filed by Merchant Banker is also placed on the website for public comments. Officials of SEBI at various levels examine the compliance with DIP guidelines and ensure that all necessary material information is disclosed in the draft offer documents.

v  With the presence of the Central Listing Authority, what would be the role of SEBI in the processing of Offer documents for an issue?

      The Central Listing Authority’s, CLA, functions have been detailed under Regulation 8 of SEBI (Central Listing Authority) Regulations, 2003 (CLA Regulations) issued on August 21, 2003 and amended up to October 14, 2003. In brief, it covers processing applications for letter precedent to listing from applicants; to make recommendations to the Board on issues pertaining to the protection of the interest of the investors in securities and development and regulation of the securities market, including the listing agreements, listing conditions and disclosures to be made in offer documents; and; to undertake any other functions as may be delegated to it by the Board from time to time. SEBI as the regulator of the securities market examines all the policy matters pertaining to issues and will continue to do so even during the existence of the CLA. Since the CLA is not yet operational, the reply to this question would be updated thereafter.

v  What is the difference between an offer document, Red Herring Prospectus, a prospectus and an abridged prospectus? What does it mean when someone says “draft offer doc”?  

      “Offer document” means Prospectus in case of a public issue or offer for sale and Letter of Offer in case of a rights issue, which is filed Registrar of Companies (ROC) and Stock Exchanges. An offer document covers all the relevant information to help an investor to make his/her investment decision. “Draft Offer document” means the offer document in draft stage. The draft offer documents are filed with SEBI, atleast 21 days prior to the filing of the Offer Document with ROC/ SEs. SEBI may specifies changes, if any, in the draft Offer Document and the issuer or the Lead Merchant banker shall carry out such changes in the draft offer document before filing the Offer Document with ROC/ SEs. The Draft Offer document is available on the SEBI website for public comments for a period of 21 days from the filing of the Draft Offer Document with SEBI.

v  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 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. An RHP for and FPO 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 ROC in terms of the provisions of the Companies Act. Only on completion of the bidding process, the details of the final price are included in the offer document. The offer document filed thereafter with ROC is called a prospectus.

v  What is an Abridged Prospectus?

      Abridged Prospectus means the memorandum as prescribed in Form 2A under sub-section (3) of section 56 of the Companies Act, 1956. It contains all the salient features of a prospectus. It accompanies the application form of public issues.   3.14 What does one mean by Lock-in?   Lock-in indicates a freeze on the shares. SEBI (DIP) Guidelines have stipulated lock-in requirements on shares of promoters mainly to ensure that the promoters or main persons who are controlling the company, shall continue to hold some minimum percentage in the company after the public issue.

v  How the word Promoter has been defined?

      The promoter has been defined as a person or persons who are in over-all control of the company, who are instrumental in the formulation of a plan or programme pursuant to which the securities are offered to the public and those named in the prospectus as promoters(s). It may be noted that a director / officer of the issuer company or person, if they are acting as such merely in their professional capacity are not be included in the definition of a promoter.

      Promoter Group' includes the promoter, an immediate relative of the promoter (i.e. any spouse of that person, or any parent, brother, sister or child of theperson or of the spouse). In case promoter is a company, a subsidiary or holding company of that company; any company in which the promoter holds 10% or more of the equity capital or which holds 10% or more of the equity capital of the Promoter; any company in which a group of individuals or companies or combinations thereof who holds 20% or more of the equity capital in that company also holds 20% or more of the equity capital of the issuer company.   In case the promoter is an individual, any company in which 10% or more of the share capital is held by the promoter or an immediate relative of the promoter' or a firm or HUF in which the 'Promoter' or any one or more of his immediate relative is a member; any company in which a company specified in (i) above, holds 10% or more, of the share capital; any HUF or firm in which the aggregate share of the promoter and his immediate relatives is equal to or more than 10% of the total, and all persons whose shareholding is aggregated for the purpose of disclosing in the prospectus "shareholding of the promoter group".

v  Who decides the price of an issue?

           Indian primary market ushered in an era of free pricing in 1992. Following this, the guidelines have provided that the issuer in consultation with Merchant Banker shall decide the price. There is no price formula stipulated by SEBI. SEBI does not play any role in price fixation. The company and merchant banker are however required to give full disclosures of the parameters which they had considered while deciding the issue price. There are two types of issues one where company and LM fix a price (called fixed price) and other, where the company and LM stipulate a floor price or a price band and leave it to market forces to determine the final price (price discovery through book building process).

v  What are Fixed Price offers?

           An issuer company is allowed to freely price the issue. The basis of issue price is disclosed in the offer document where the issuer discloses in detail about the qualitative and quantitative factors justifying the issue price. The Issuer company can mention a price band of 20% (cap in the price band should not be more than 20% of the floor price) in the Draft offer documents filed with SEBI and actual price can be determined at a later date before filing of the final offer document with SEBI / ROCs.  

BIBLIOGRAPHY: Chapter 2, Investment Banking: The Dream Begins (4th Edition)