Why IPOs have a Discounted Price to Issue Price?

Introduction on IPO

Investment decisions involve a great amount of uncertainty and the actual difference between expected and accumulated benefits is where the risk comes in. In a dynamic market economy, there are instances when a company has to accumulate funds from the general public by offering them stakes in the form of shares. This enables the issuing company to procure sufficient financial resources for the task at hand. An Initial Public Offering (IPO) is the mechanism through which companies issue shares for eligible investors as per the guidelines of the Securities and Exchange Board of India (SEBI). These public offerings work through a channel that is beneficial for both the issues as well as for the investors. 

An IPO therefore serves as a capital building tool for the company in question. Such public offerings are frequently seen as a sort of venture capital generation. However, the mutual inclusiveness that Direct Public Offering gives works to the best of broader market interests. Therefore, it can be safely assumed that the pricing factor of an IPO holds the key to the net profitability of the offering for the investors. On the other hand, if we look more closely at the profitability of a company, then it is a well-known fact that operating and financial leverages are measured in relative terms to assess their impact on the profitability of a company. These measures are given by the degrees of operating and financial leverages. Therefore, from a company’s point of view, an IPO serves as an enhancer of the core financial strength.

How price is discounted

In accordance with the SEBI Regulations, a public issue of securities is an offer of equity shares or securities convertible into equity shares by an unlisted company, by way of an initial public offer or by way of a further public offer by a listed company to the public. A public issue may also be made through an offer for sale of securities by existing holders of such securities, subject to satisfaction of certain conditions. Money saved over a period of time yields interest and herein lies the concept of the time value of money. It has been suggested that the acceptability or otherwise of an investment should be judged from its principle.  

A pre-IPO placement refers to the issuance of equity shares, or securities convertible into equity shares, by an issuer after filing of the Draft Red Herring Prospectus with SEBI and prior to the filing of Red Herring Prospectus. The Draft Red Herring Prospectus is required to disclose the maximum number of equity shares that may be issued and the maximum amount to be raised. 

In terms of the SEBI Regulations, not less than 20% of the post-IPO equity share capital should have been contributed by a promoter in the IPO. For the calculation of promoters’ contribution, the following securities, amongst others, shall be ineligible for the computation of promoters’ contribution: lf the securities that have not been acquired in the last three years for consideration other than cash and revaluation of assets or capitalisation of intangible assets; l Equity shares acquired through a bonus issue of equity shares out of revaluation reserves or unrealised profits of the issuer or bonus equity shares acquired on the basis of ineligible equity shares in the last three years; or l Equity shares acquired during the preceding one year and at a price lower than the price at which the equity shares are being offered to the public in the IPO, subject to certain other requirements.

In terms of the SEBI Regulations, lock-in requirements are of two types: (i) that which applies to the promoters of the issuer in respect of the promoters’ contribution; and (ii) that which applies to all holders of the pre-IPO equity share capital of the issuer (including, the promoters for their holding in excess of the promoters’ contribution). The issuer should not schedule any interviews with representatives of the international or Indian press or hold investor meetings or participate in the industry conferences without consulting their legal counsel. The issuer should not respond to any inquiries from the press without prior consultation with its legal counsel.

Why IPO is the best way of investing

In an IPO offering, the company sells the shares to its investors at a particular price, which is known as the offering price. Now when the market opens for trading, the price at which these shares start to trade is different from the offering price and is known as the opening price. The margin for this variation is where the profit or the loss of the investors comes in. This is because this particular variation is a showcase for the impending variation to the net amount that an investor may earn or lose. Following the usual process, a company uses the services of a financial institution that is known as the “Underwriter”. This underwriter is the agency that plans and executes the IPO and hence, decides on the price structure for that particular IPO. Finalisation of the IPO price and filing of the final Prospectus with Registrar of Companies and execution of the Underwriting Agreement then takes place in the due course of time.

Allocation is made to the investors and the investors are required to bring in the additional amount. However, if the final IPO price is lower than the price at which the allocation is made to investors, the excess amount cannot be refunded to the investor and thus, as a result of this, the investor shall receive allotment at the higher price. Under the SEBI Regulations, an issuer may determine the price (and, in the case of convertible debt instruments, the coupon rate and the conversion price) in consultation with the underwriter i.e. the bank that has decided the pricing structure of the IPO. 

After the determination of the IPO price, the maximum number of equity shares bid for by a Bidder at or above the IPO price is considered for allocation and the rest of the Bid(s), irrespective of the bid price, are automatically rejected.

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