What is an IPO: Meaning, Advantages, Disadvantages & More

An initial public offering (IPO) occurs when a company offers shares to the general public for the first time. A private company becomes public when it decides to make an offering to the general public. It means that a company, which until that point was privately held, becomes publicly traded.

The shareholders of a company are very few before the IPO. Angel investors, venture capitalists, and founders constitute these investors. In contrast, a company's shares are made available for sale to the public during an IPO. Thus, you can become a shareholder by purchasing shares of the company directly from the company.

Advantages of an IPO

1. Obtaining Capital

IPOs and subsequent rounds of funding provide substantial sums of capital to fund expansion, growth opportunities, product development, marketing, and capital expenditures.

Whether traded through a public exchange or a privately held stock exchange, shares on a public exchange are more liquid. As a result, the stock price and market capitalisation of the company are higher.

3. M&A Transaction Funding

When a company's stock is valued higher, more cash can be raised, or fewer shares can be exchanged to complete corporate M&A transactions. A future IPO or stock offering can generate cash proceeds for M&A deals. Synergies and increased earnings are outcomes of successful mergers and acquisitions.

4. Reduce corporate debt

Companies with public offerings often retire debt to lower interest costs, generate better cash flow, and increase their debt-to-equity ratio.

5. Becoming more known and maintaining your brand identity

Rather than being acquired, the corporation keeps its corporate name and status if it chooses to go public as its exit strategy. Thus, in addition to the company's continuing nature and its name recognition, its founder may see the significance in it.

Through press releases and coverage in the financial media, companies are more recognisable and attract new customers and strategic partners. In addition, publicly, public companies tend to be more transparent due to their obligation to share information, such as financial statements.

6. Retaining and Attracting Employees

Stock grants and public stock options can enable companies to attract employees with low-risk tolerance. In addition, employees with current stock options are eligible for discounted stock purchases.

Entrepreneurial employees may get greater stock rewards when investing in the company at the pre-IPO stage than employees in large public companies.

IPOs Have Several Disadvantages

1. Commitment to Time

Before a company's IPO on the stock exchange, the public offering process takes at least two years.

Select the managerial team for the IPO as well as the management. Financial statements, as well as legal agreements need to be updated and audited. The systems must be ready. Financial information from the past and the present is essential.

An application is necessary to list on the stock exchange. The SEC's Corporate Finance Division must review a registration statement, including the prospectus, before filing. A registration statement cannot become effective until their comments have been cleared.

Investor relations professionals and IPO experts need to help develop and practice presentations. In addition, company management needs to behave more like an open corporation and present financial information on par with a public corporation.

Investors are selected as lead underwriters by the company. Underwriting is used to allocate shares from underwritten IPO investors to public offering investors.

As part of the company's obligations as a public company, including regulatory filings, financial statements, and annual shareholder meetings, CEOs and CFOs will be required to devote time to these tasks.

2. Missed opportunities and distractions from the business

Several projects are completed, and meetings are held as part of the listing process, increasing employees' workload. Occasionally, we will fail to accomplish a task or make a mistake. As a result, the IPO may cause the company to miss out on potential revenue opportunities. As a result, the payroll will have to increase to protect against these risks.

A heavy underwriting commission is charged to the investment banker syndicate serving as underwriters. However, due to underwriting fees being deducted from IPO gross proceeds, this disadvantage is mitigated due to the size of the IPO company's capital raise.

4. The focus should be on quarterly results.

The focus should not be just on long-term business plans but on short-term ways to achieve profit or revenue forecasts. The stock price typically drops precipitously when financial estimates fail to meet expectations. For company management, this approach may frustrate them.

5. Scrutiny of public information

While private companies have a reputation for providing confidential information, they should prepare public financial reports and disclose information to customers and competitors. It's possible that a company may not do an IPO if it strongly believes in protecting personal information.

6. Incomplete IPOs pose a risk.

Consider the case where capital markets do not favour the completion of an IPO. A company's costs and time spent on Public Company Accounting Oversight Board (PCAOB) compliance audits, consulting firms, and securities law firms will not have any point if it does not receive IPO proceeds.

7. Capitalisation rate that is higher than the weighted average

Capital asset pricing model (CAPM) determinations of the cost of equity are higher than those made by using the cost of debt. Therefore, raising new public equity will increase the company's weighted average cost of capital (WACC). When evaluating investments that are expected to boost growth, WACC is used as a hurdle rate. However, a significant sum may get raised through an IPO, so this objection is offset.

In what ways can IPOs benefit you?

1. Advantage of being the first to move

A recent IPO announcement by a reputed company is an excellent example of this. Buying the shares at a lower price will give you a chance to save a lot of money. However, since the share price may increase significantly once its shares hit the secondary market, it is typical for the share price to spike.

2. High return on investment

Buying shares of an IPO can be beneficial if the company has growth potential. This company has strong fundamentals that give it a strong chance of growing. Furthermore, this can be beneficial to you as well. Over the long run, you may be able to earn good returns.

3. Gains on listing

Depending on how the company is listed, it may be traded higher or lower than the allotment price. It is called a listing gain when the opening price is higher than the allotment price.

Market demand and positive bias are factors that determine how well an IPO performs on the listing. Unfortunately, it doesn't always happen that way. The first trading day can also bring about a decline in stock prices.

It is possible that listings gains do not result in good returns for investors over the long run. It may be suitable for traders looking for quick returns. Long-term investors, however, should seek out companies that will offer high returns five to ten years down the road.

To sum up

There is a reason why IPOs are considered significant events in the stock market. You can earn good returns in the long run if you invest in the right company. After that, it's just a matter of identifying the good performers among the rest.

Also Read:

1) Pros and Cons of Cheque payments
2) All You Need to Know About Electronic Checks
3) Digital Payments: Definition and Methods
4) Differences between E-checks and Paper Checks

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FAQs

Q. How do price bands work?

Ans. When sellers bid on item security during an initial public offering (IPO), Bids are placed between price bands.

Q. Is there a "Minimum Order Quantity" for an IPO?

Ans. In an IPO, Minimum Order Quantity is the number of shares that investors must apply for to bid. IPO bidders can submit multiples of the market lot (aka the IPO bid lot) of shares if they wish to bid for more shares.

Q. Cut off price: what is it?

Ans. Cutting-off price refers to the offer finalised by a company in consultation with book running lead managers (BRLMs), which may be outside the price band. The company may decide to price the stock at a higher or lower level at the end of the book-building process.

Q. How many bids are allowed per investor?

Ans. An investor can place a maximum of three bids on an issue.