Why does a company go for an IPO?

Last Updated: Mon, Jan 14, 2008 11:47 hrs

Characters: Neha, 22 years, engineering student.

Vijay, 24-year-old chartered accountant, Neha’s brother.

Renuka, 48 years, housewife, Neha’s mom.

Rajesh, 52 years, banker, Neha’s dad.

“Hi everyone,” said Neha, as she came home from college and walked into the living room, where her family was having hot pakodas. After freshening up, she came and sat next to her dad. He looked at her inquiringly. Popping a piece of pakoda into her mouth, she said: “Dad, I’ve decided to invest my savings.” Her brother laughed aloud. “Have you won a lottery? I didn’t know you had so much excess savings. You can lend me some money and I’ll invest it if you want.”

“Ha, ha”, replied his dad in a bored voice. “It is actually a very good idea to invest your savings. What do you have in mind Neha?” he asked.

“I hear that a very reputed company is coming out with an Initial Public Offering (IPO). Can I invest in that?”

Her mom overheard and paused to ask: “What is an IPO and how does it work?”

Vijay began speaking: “An IPO is the first sale of stock by a company. Companies looking to expand their operations often use an IPO as a means to generate the capital. Although expansion may be beneficial to the company, there are both advantages and disadvantages in going public”

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“Well, I get it,” said Renuka thoughtfully. “But what are the advantages for the company in coming out with an IPO?”

Pluses of IPO

Her husband answered: “The company has many advantages in going public. The financial benefit of raising capital is the most distinct advantage. Capital raised can be used to fund R&D and capital expenditure or even used to pay off debt. Another advantage is increased public awareness of the company. This may even increase the market share of the company. An IPO also may help promoters exit from the company. ”

Neha spoke up: “What I can’t see are the challenges in the company going public.”

Vijay looked at her and said: “Benefits apart, companies often face many challenges. One of the most important changes is the need for added disclosure to investors. Public companies are regulated by the Securities Exchange Act of 1934 in regard to periodic financial reporting, which may be difficult for newer public companies.

“They must also meet other rules and regulations that are monitored by the Securities and Exchange Commission (SEC). For smaller companies, the cost of complying with regulatory requirements can be very high. These costs have only increased with the advent of the Sarbanes-Oxley Act. Some of the additional costs include the generation of financial reporting documents, audit fees, investor relation departments and accounting oversight committees.

“Public companies also face added pressure from the market which may cause them to focus more on short-term results rather than long-term growth. The actions of the company’s management may come under increased scrutiny as investors constantly look for profits..”

Getting allotment

Neha persisted: “But how will the shares get allotted to me?”

Her dad explained: “Getting allotment of a hot IPO is very difficult, if not impossible. To understand why, we need to know how an IPO is done, a process known as underwriting.

“When a company decides to go public, it first goes to an investment bank. Though a company could theoretically sell its shares on its own, it may still need the service of an investment bank. Underwriting is the process of raising money through debt or equity (in this case we are referring to equity).

“As the road to an IPO is complicated, we may often notice retail investors don’t jump in till the end. This is because small investors are not the target market. However, all that might change with some big-ticket IPOs set to hit the market. ”

Renuka asked: “Isn’t it a risky investment? How will you know if the company is secure?”

Special attention

This time Neha replied: “It is difficult to analyse a company that is coming out with an IPO as it will not have any historical information. The main source of data is the red herring prospectus, which should be examined carefully. One should pay special attention to learning about the management team and how it plans to utilise the funds generated through the IPO.

“It is important to understand that underwriters are salesmen. The whole underwriting process is well publicised to draw as much attention, as IPOs are a ‘once-in-a lifetime’ event for a company. Of course, after listing, while some company stocks soar, others end up quoting below their offer price within a year.”

Vijay patted his daughter on her head as he left the room, “So investing in an IPO is noteasy. A lot of factors have to be taken into consideration. Be vigilant and do not fall for hype. Make an informed decision.”

Neha called after him and said: “I was wondering if I could start a company and sell some shares to you and mom. Can I borrow Rs 500 against the money you owe me for that stock now?”

“Yeah, right!” her mom laughed.

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