23-Oct-2023
2 mins read
In 2023, Indian investors were excited about IPOs. The Indian IPO market has been gaining momentum in 2023. Investors are excited about IPOs because they believe they have the potential to bring in big returns. As a matter of fact, 9 out of 12 stocks listed in 2023 experienced net gains on their debut.
But why the IPO frenzy in today’s market, spanning startups, established firms, and medium-sized enterprises? There is a straightforward reason: IPOs serve as a means for previously unlisted or privately traded companies to secure capital from the public market. An IPO is when a private company sells its first shares to the public. The company decides on a price for these shares and offers them for sale during the IPO. Investors can become company owners by buying their shares. If the company does well, it can get dividends and make money by selling shares if their prices go up. But why do companies go public?
Every private firm faces the decision of remaining private or opting for a public offering. In India, the Securities and Exchange Board has specific prerequisites, including financial transparency. This article will explore the merits and demerits of going public and how it can benefit investors.
Why Do Companies Go Public?
Capital is crucial for launching and expanding a business. Initially, founders, friends, family, and private investors often provide the necessary funds. As a company grows, its operational cash needs grow as well, necessitating additional funding sources to sustain and scale its operations.
While companies have various funding options like private investors and bank loans, many opt for going public through an IPO due to its numerous advantages. Going public involves selling company shares to the public in exchange for capital, essentially trading ownership stakes for funds. This strategic move can give companies access to a broader investor base and increased financial resources for growth and development.
Why Do Companies Launch an IPO?
Companies launch an Initial Public Offering for various reasons, including:
- Access to Capital
Launching an IPO allows companies to access significant capital by selling shares to the public. This influx of funds can be instrumental in financing various strategic endeavours. These strategic endeavours are such as expanding operations, investing in research and development, reducing debt burdens, or seizing new market opportunities. By going public, businesses gain the ability to tap into a wide and diverse investor base, thus securing the financial resources necessary for their growth and development.
- Liquidity for Founders and Investors
Liquidity for founders and investors is a crucial aspect of launching an IPO. Going public allows early investors and company founders to convert their ownership stakes into readily tradable shares. This provides an avenue to sell their holdings and realise their investments. This liquidity not only offers an exit strategy but also attracts new investors who are more inclined to invest in a publicly traded entity, thereby increasing the company’s overall appeal in the financial market.
- Employee Incentives
Employee Incentives highlight that companies launch IPOs to motivate and retain their employees. Going public enables businesses to offer stock options and equity-based compensation to their workforce. These incentives align employees’ financial interests with the company’s performance and growth, promoting a sense of ownership and dedication. Such programs attract top talent and encourage long-term commitment, as employees share in the potential financial rewards as the company’s stock value appreciates, thus driving collective efforts toward the company’s success.
- Enhanced Visibility and Credibility
After becoming public, a company can utilise its publicly traded shares to buy other companies. The corporation can give its stock to the target shareholders instead of paying cash for acquisitions. This can be advantageous because it allows the acquiring company to preserve its cash reserves while pursuing strategic acquisitions. Using its stock as currency, the public company can efficiently expand its operations and portfolio, creating opportunities for growth and diversification in a competitive business landscape.
- Acquisition Currency
Going public transforms, a company’s stock into a valuable currency for acquisitions. Publicly traded companies can use their shares to acquire other businesses, providing an advantageous tool for growth through mergers and acquisitions (M&A). By offering stock as part of the deal, a public company can entice potential acquisition targets and negotiate more favourable terms. This strategy allows companies to expand their operations, product offerings, and market presence, leveraging their publicly traded status to access resources and opportunities that might otherwise be challenging to secure as a private entity.
- Exit Strategy for Early Investors
Exit Strategy for Early Investors refers to the attractiveness of going public for venture capitalists and angel investors who have invested in a private company. These early-stage investors seek opportunities to realise returns on their investments. When a company conducts an IPO, these investors can sell their shares to the public market, providing an exit strategy. This liquidity event allows them to convert their equity stakes into cash, realising profits or recouping their initial investments. It’s a crucial benefit of going public that incentivises early investors to support and fund promising startups, knowing that there’s a potential path to monetising their investments in the future.
- Regulatory Requirements
Some companies opt for an IPO due to regulatory requirements. As a company grows in size and reach, it may come under the purview of various regulations, making public listing a more practical choice. Going public enables compliance with regulatory obligations and reporting standards, which can be crucial for industries like finance and healthcare. By going public, the company shows its transparency and accountability, which can boost investor trust and attract more stakeholders. It also requires stringent governance and reporting standards and increasing regulatory monitoring, which can be resource-intensive.
- Employee Stock Option Plans (ESOPs)
An IPO enables companies to reward and retain employees through ESOPs. Employees receive stock options, allowing them to purchase company shares at a predetermined price. Going public often increases the value of these options, serving as a powerful employee incentive. It aligns employees’ interests with the company’s success, fostering loyalty and motivation while helping the firm attract and retain top talent.
- Increased Transparency
Increased Transparency refers to the regulatory and reporting requirements that come with going public through an IPO. Companies must disclose their financial information, operations, and governance practices to the public and regulatory authorities. This transparency builds trust among investors, as they have access to reliable information. It also fosters better corporate governance, reducing the risk of fraud or unethical practices.
In India, for instance, the SEBI mandates these disclosure standards, ensuring that publicly traded companies adhere to higher levels of accountability and financial openness for the benefit of shareholders and the broader market.
Disadvantages of Going Public
Going public, while offering several advantages, also comes with its fair share of disadvantages. The following are some key drawbacks associated with taking a company public:
- Costs and Regulatory Compliance
Going public incurs substantial costs related to regulatory compliance. Publicly traded companies must adhere to strict reporting standards, necessitating comprehensive financial audits, legal consultations, and ongoing compliance efforts. These expenses, including filing fees, listing fees on stock exchanges, and expenses associated with governance and transparency, can significantly increase a company’s operational overhead. Compliance with these regulatory obligations represents a significant financial burden for companies transitioning from private to public status, impacting their overall cost structure.
- Loss of Control
The second disadvantage of going public is the potential loss of control for the company’s founders and early investors. As a company issue more shares to the public, ownership becomes dispersed among a broader group of shareholders, each with voting rights. This dilution of ownership can reduce decision-making authority for the original stakeholders. This makes it challenging to maintain the same level of control over the company’s strategic direction and operational decisions, ultimately impacting the direction and vision of the business.
- Short-Term Focus
Another potential drawback of going public is that companies may become overly focused on short-term financial performance. Publicly traded firms often face pressure to consistently meet quarterly earnings expectations, discouraging long-term investments and innovation. This short-term focus may lead to decisions prioritising immediate profits over the company’s future growth and sustainability. Investors and analysts analyse quarterly financial reports, affecting the company’s strategic orientation and making it difficult to balance short-term outcomes and long-term strategy.
- Disclosure of Sensitive Information
When a company goes public, it must disclose extensive financial and operational details to the public, including competitors and potential adversaries. This transparency, while necessary for regulatory compliance, exposes sensitive business information and strategic secrets. Competitors can gain insights into a company’s operations, pricing strategies, and market positions, potentially compromising its competitive advantage. In the public domain, protecting proprietary information requires strong safeguards and careful disclosure, balancing regulatory compliance and data security.
- Market Volatility
Market volatility refers to the unpredictable fluctuations in a publicly traded company’s stock price. This can result from various factors beyond the company’s control:
- Economic Conditions: Changes in the overall economy can impact investor sentiment and stock prices.
- Industry Trends: Sector-specific trends and news can influence stock values.
- Market Sentiment: Investor emotions and perceptions can cause rapid price swings.
- External Events: Global events, geopolitical tensions, or natural disasters may affect markets.
- Speculation: Speculative trading can lead to abrupt price movements, creating uncertainty for investors.
- Supply and Demand: Sudden shifts in buying or selling pressure can drive price volatility. This volatility can challenge long-term planning and investor confidence.
- Pressure for Quarterly Growth
Publicly traded companies face relentless pressure to consistently deliver strong financial results every quarter. Investors, analysts, and the broader market scrutinise these short-term performance metrics closely. This intense focus on quarterly growth can lead to decision-making prioritising immediate gains over sustainable, long-term strategies. Companies may resort to cost-cutting measures or aggressive revenue-boosting tactics to meet these expectations, potentially sacrificing innovation and stability in the process. This pressure for continuous short-term growth can hinder a company’s ability to plan and invest strategically for the future.
- Liquidity Constraints
Going public offers liquidity to company founders and early investors by allowing them to sell their shares on the stock market. However, it introduces constraints. Insider trading restrictions and lock-up periods can limit their ability to sell shares when they wish. Insider trading regulations prohibit certain individuals with access to privileged information from trading shares at specific times, while lock-up periods, typically imposed after an IPO, prevent insiders from selling their shares immediately. This reduces their flexibility and potentially affects their ability to realise the full value of their holdings.
Key IPO Terms
Understanding the technical terms associated with Initial Public Offerings (IPOs) is important for anyone interested in this domain. Here are some commonly used IPO-related terms and their definitions:
- IPO: A stock exchange is used to sell a private company’s shares to the public and institutional investors in an IPO. It marks the company’s stock market debut and offers investors ownership stakes. IPOs are significant as they provide businesses with capital for growth, expansion, or debt repayment while allowing investors to potentially profit from the company’s future success through share ownership. The IPO process involves rigorous regulatory scrutiny and the issuance of a prospectus containing vital information about the company’s financials and operations.
- Venture: Venture capital in India is a form of private investment that supports promising startups in their early stages. Venture capital firms provide funding to these startups in exchange for equity ownership. They actively assist in their growth and development, often offering guidance and mentorship. This form of financing is vital for startups with high growth potential but limited resources. It fuels innovation, fosters entrepreneurship, and plays a significant role in India’s evolving tech and startup ecosystem, driving economic growth and job creation.
- Market Capitalisation: Market capitalisation represents a company’s outstanding shares and overall market value. It’s computed by multiplying the market price per share by the public share count. Investors use market cap to evaluate a company’s size and stock market importance. Higher market caps signify larger, more established companies, whereas lower ones may represent smaller or newer ones.
Market Capitalisation formula:
Market Cap = Current Market Price per Share x Total Outstanding Shares
- Current Market Price per Share:This is the stock market price of one firm share. It fluctuates with supply and demand during the trading day.
- Total Outstanding Shares:This includes both common and publicly traded preferred shares of the company’s stock that investors own.
It’s a key metric used for comparisons, investment decisions, and inclusion in stock market indices.
- Issuer: The “Issuer” in an Indian Initial Public Offering refers to the company that intends to go public by offering its shares to the general public for the first time. This pivotal entity seeks to raise capital by issuing a portion of its ownership in the form of shares. IPOs allow private companies to become publicly listed on stock exchanges. In the IPO prospectus, the issuer describes its business, financial performance, and growth prospects to attract investors and raise funds for expansion, debt reduction, or working capital.
How to Invest in an IPO
As an individual investor, participating in IPOs can be challenging due to limited access and competition for shares. To invest in IPOs, you’ll typically need an account with a brokerage like Bigul that offers IPO access. Many brokerages also require a certain investment amount or high trade activity to qualify for IPO participation. Getting shares at a favourable price during an IPO can be tough because early access goes to founders, friends, and institutional investors, who often secure discounted prices.
However, brokerages like SoFi and Robinhood may provide their clients with earlier access to IPO shares, potentially allowing for better pricing. Still, you’ll need sufficient funds to meet the minimum lot size, and thorough research on the company is essential before investing in its IPO. So basically, while IPO participation is possible for individual investors through certain brokerages, it often requires careful planning and research to make informed investment decisions.
Conclusion
Going public through an Initial Public Offering is a significant decision for companies, driven by various compelling factors. It provides access to substantial capital liquidity for founders and investors and enhances visibility and credibility. Additionally, it can be a strategic move for acquisitions and serves as an exit strategy for early investors. However, companies must navigate the challenges of increased regulation and market volatility.
Ultimately, the decision to go public should be a well-thought-out one, considering both the benefits and risks in the ever-evolving landscape of the financial markets.
FAQs
- Why do companies decide to go public and launch IPOs?
Companies go public through IPOs to raise capital from public investors, enabling them to fund growth, expand operations, and pursue strategic initiatives.
- Is there a specific size or industry that’s more likely to go public?
Companies of varying sizes and industries can go public. While technology companies are often in the spotlight, IPOs can be suitable for any firm seeking growth and capital.
- Do companies lose control when they go public?
Companies may dilute their ownership when going public, but they often retain control through dual-class share structures or maintaining a significant portion of shares.
- How does going public affect a company’s financial transparency?
Going public requires companies to disclose financial information and adhere to regulatory requirements, which increases transparency and builds trust with investors.
- What are some challenges associated with going public?
Challenges include regulatory compliance, increased scrutiny, pressure for short-term results, and the need to manage shareholders’ expectations.
- Can a company go public if it’s not profitable?
Yes, a company can go public without being profitable, but it must convince investors of its growth potential and demonstrate a clear path to profitability to attract investment interest.