Initial Public Offering (IPO)




Initial Public Offering (“IPO”) is one of the mechanisms for incorporated entities to raise funds. It refers to the process of a private company going public. It is the stage at which a company first sells its shares to the public. IPO enables a private company to access for the first time, capital from the entire investor public by issuing its equity to these investors. The Company conducting an IPO is referred to as the “Issuer”.


Evolution of this fundraising mechanism

Amsterdam was active with mercantile ventures even at the onset of the Dutch Golden Age. It housed various companies engaged in trade, these were retrospectively called ‘voorcompagnieen’ in Dutch. These firms founded in the late 1500s were led by ‘bewindhebbers’ who actively managed the companies which were in turn capitalized by passive ‘participantem’ invited to acquire a fractional interest in the companies’ profits. [1] These firms were set up for a single voyage and liquidated after its completion. A new firm would be established for each voyage.[2]


During the seventeenth century, spices were immensely popular in Europe and were considered ‘exotic’. A huge spice trade existed to source these rare substances. To ensure the success of these expeditions, the government granted legal monopolies to trading corporations. The Dutch East India Company or the Vereenigde Oost-Indische Campagnie (“VOC”) as it was known then, was chartered in 1602 by merging six existing voorcompagnieens.[3] The VOC was granted a monopoly on trade with Asia.


VOC was the first corporation known to have conducted an IPO of modern style. VOC's charter is historic for its contribution to what is offered to the world of finance. It says that “All of the residents of these United Provinces shall be allowed to participate in this Company and to do so with as little or as great an amount of money as they chose” – Charter of the Dutch East India Company, 1602.”


The offering period ran for months with the firm’s charter having allocated a particular fraction of the company’s capital to each region in the country, which it was responsible for raising. Over 1100 investors subscribed to the IPO in Amsterdam alone.


Although the VOC’s initial charter gave shareholders the right to withdraw their capital contributions after the first ten years, a subsequent charter amendment orchestrated by bewinhebbers and the state eliminated this right, effectively locking in outside investors against their will. Dividends were sometimes paid in kind – in mace, pepper and nutmeg when the market price for these commodities was particularly low due to excess supply.[4]


The formation of a secondary market for shares of the VOC culminated into the formation of none other than the Amsterdam Stock Exchange, arguably the oldest in the world. Though compared to modern standards the process of trading was naturally cumbersome. Regardless, a secondary market in any form was quite unprecedented at the time. Contrastingly, shares of the British East India Company which was founded two years earlier were not transferable.


Secondary market comprising of stock exchanges enabled companies to easily raise capital and lock it up for longer, which is one of the characteristic feature fo modern corporations.


Concept

When a private company resolves to go public, it conducts an IPO. An IPO involves offering the company’s shares in a new stock issuance. This is usually done with a view to raising capital from the public through the issuance of public share ownership.


A private company’s business is made up of of a comparatively lesser number of shareholders which may include early-stage investors such as founders as also specialized investors such as venture capitalists or angel investors.


A private company typically considers going public when it attains a level in its growth where it supposes it is ready to read the advantages and accountabilities of public shareholders. Characteristically, this stage of growth will occur when a company reaches unicorn status (a tag granted to startups with valuations over 1 Billion USD) in valuation. Although, consideration to go public is also present for private companies of lesser valuations which still have solid fundamentals and demonstrated profitability prospective and their projected ability to meet listing requirements.


Interesting Read: India’s new Unicorns.


IPO is undoubtedly a stepping stone for a company. It opens up new avenues of capital raising, which provides the company with a fortified power to expand and flourish.


A public company is also referred to as a publicly listed or a publicly-traded company, it refers to one whose ownership is organized as shares of stock. These stocks are freely traded on a stock exchange and essentially allows members of the public to be part owners in the company.[6]


Considerations before proceeding to go public

Going public has its own set of advantages and disadvantages, but it can be said to have on balance, more positive results.


Pros

As it is the primary aim, IPO indeed helps corporations to raise capital. The company gets access to investment from the entire investment public to raise capital, which can be used to reduce the overall cost of capital or to expand research or to get a new level of product development. It can also be used to clear the previous debt.


Going public increases the disclosures requirements that a company gives to the public, which in turn increases transparency. This, in turn, places public companies in a better standing while negotiating with banks and financial institutions as public companies often receive more favourable credit borrowing terms compared to private companies.


It can increase the company’s exposure, prestige and public image which can help the company’s sale and profits. Public companies can attract and retain better management and skilled employees through employee stock option participation.


Often times, business owners of growing businesses are vary of the chance of losing a lot of money. In this case, IPO offers an opportunity to spread the risk of owning the business among the large group of shareholders. Thus, it is also a strong exit strategy for business owners who have worked to build a profitable company and wish to retire from the venture.


Cons

The process of IPO involves the appointment of several intermediaries and high costs of conducting. Besides the one time expensive process, it is also costly to maintain a public company, which is relatively continuous.


The company becomes required to disclose financial, accounting and tax and other business information. During these disclosures, it may have to publicly reveal secrets and business methods that could help it's competitor. But this also increases the time and effort as well as attention of management on correct reporting. There are costs which include significant legal (due to increased risk of legal and regulatory issues such as private securities class action suits and shareholders actions), accounting and marketing costs. These expenses are usually unrelated to the other costs of doing business.


There is always a risk that required funding will not be raised if the market does not accept the IPO price.


While initial funders may have been Venture capitalists and angel investors, they might exit after reaping the IPO benefits. As new shareholders enter the company who obtain voting rights and ability to effectively control company decisions via the Board of Directors, there arise agency issues. It does bring up the potential difficulty to focus on the company’s long term growth when public investors want to see immediate results and have a say in management decisions. There is consequently, a loss of independence for the founders who remain part of the company.


The focus of the management may get sidetracked by the fluctuations in the company’s share prices as they may be compensated and their performance evaluated based on stock performance rather than actual results. The management may also become burdened by the oversight of disclosure and other requirements placed by the market regulator on listed companies.


Investing in IPO

The above considerations are crucial for a determination as to whether a company should or should not proceed with an IPO. Thus, companies usually conduct an in-depth analysis of the long term impact of going public, before doing so. The company has to necessarily ensure that going forward, the public issue would raise the highest capital for the business. And archetypically, when this decision is made, it is done so on the basis of prospects of relatively exponential future growth.


Regulatory Considerations



Routes for IPO based on eligibility

SEBI has stipulated certain norms which companies need to fulfil in order to become eligible for conducting IPO under Regulation 6 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 ("ICDR").


Profitability route is the first route, wherein the company must have a minimum net worth of INR 1 Crore in each preceding three years. The company must also have a minimum INR 15 Crore average pre-tax operating profit in at least three of the preceding five years. Additionally, it must have a minimum net tangible asset of at least INR 3 Crore in each of the preceding three years, of which not more than 50% are held in monetary assets. However, this limit of 50% is not applicable in case the public offer is entirely made through an offer for sale. Furthermore, in case of a change in the name of the company, at least 50% of the revenue for the preceding one year should be from the activity denoted by the new name.

Finally, the issue size must not exceed 5 times the pre-issue net worth as per the audited balance sheet of the preceding financial year.


In order to promote other companies who do not meet profitability standards to go public, SEBI has provided for alternative eligibility criteria for IPO:

QIB Route enables the companies to access public interest through the book-building process. In this, Issue, at least 75% of the net offer to the public to be mandatory allotted to the Qualified Institutional Buyers (QIBs). The company shall refund the subscription money if the minimum subscription of QIBs is not attained.


Other general regulatory considerations

Per Regulation 5 of the ICDR, eligible companies must also ensure that none of its promoters, directors or other persons in control is debarred from accessing the capital market and that none of these persons is playing similar roles in other companies. Regulation 7 of the ICDR requires all partly paid-up equity shares of the company must be fully paid up. Regulation 7 also requires the issuer to enter into agreements with a depository for dematerialization of specified securities and also to make an application to recognized stock exchanges for the listing of its shares.


The minimum Issue Size for an IPO must be INR 50 Lakh.


Regulation 14 prescribed the minimum promoters contribution by an unlisted issuer is 20% of the post-issue capital, which comes with a lock-in period of 3 years. The remaining pre-issue capital of the promoters should also be locked in for a period of 1 year from the date of listing. This is aimed to ensure the promoters' minimum stake in the company for a minimum period after issue after funds are raised from the public.



Issue Type based on pricing

On the basis of Pricing, an issue can be further classified into two:


Fixed Price Issue

In this type of issue, the issuer decides the price at the outset and discloses the same in the offer documents.

Book Built Issue

In this type of issue, the price of an issue is discovered based on the demand received from prospective investors. Issuers are required to disclose information pertaining to the price band at least 5 working days prior to the opening of an issue. The applicants bid for the shares quoting the price and quantity that they would like to bid at. On the basis of demand at various price levels within the price band, the Lead Manager, in consultation with the issuer arrives at the cut-off price at which the securities of the issuer are offered and issued.


Intermediaries involved


Various SEBI registered intermediaries are involved in IPO across its various stages. Following are the intermediaries that play a major role in the process.


Merchant Bankers conduct the due diligence and aid issuer in preparation of the various offer documents. They are also to ensure compliance with all legal formalities in the entire issue process. Besides this, they conduct marketing of the issue and also act as Lead Managers in case of book-built public issue.


Registrars to the issue are, inter alia, responsible for finalizing the basis of allotment in an issue, for keeping all allotment details and also for ensuring refunds are correctly made.


Bankers to issue ensure seamless movement of funds during the process to in turn enable registrars in finalizing the basis of allotment by making clear funds status available to the Registrars.


Underwriters first purchase or underwrite the securities of the issuer and eventually sell them in the market to ensure that the issuer can raise the maximum amount of capital. Underwriters charge a premium in return for their service.

A prospective issuer must ensure compliance with all requirements of ICDR prior to approaching SEBI. SEBI examines the compliance of ICDR Regulations at the time of IPO as well as after the completion of the issue.


Further reads: Security Token Offering: Compelling Regulatory Opportunity for India.

[1] Henry Hansmann and Mariana Pargendler, The Evolution of Shareholder Voting Rights: Separation of Ownership and Consumption, YLJ, Vol. 123, No. 4 (January, 2014), pp. 948-1013. [2] Ron Harris, Law, Finance and the First Corporations, in GLOBAL PERSPECTIVES ON THE RULE OF LAW 144,156 (James J. Heckman et al. eds., 2010). [3] Andrew von Nordenflycht, The Great Expropriation: Interpreting the Innovation "Permanent Capital" at the Dutch East India Companies, in Origins of Shareholder Advocacy. [4] Supra, note 1. [5] https://thetchblog.com/2019/11/18/the-first-ipo/ [6] https://www.investopedia.com/terms/p/publiccompany.asp

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