Investing in an Initial Public Offering? Here are 10 IPO terms to know
While the first half of 2023 was rather lacklustre for public issuance, the second half seems abuzz for the IPO market. If you want to invest in an upcoming listing, here are some of the basic terms you need to know.
"Risk comes from not knowing what you're doing." - Warren Buffet
The first time a company decides to open its shares to the general public for investment is a moment of reckoning. It’s a way to test the market’s faith in your company. For example, in the international market, popular companies like Stripe and Discord are going to offer their shares for the first time in 2023. Closer home, foodtech unicorn Swiggy is allegedly preparing for its own initial public offering (IPO).
When you invest in an IPO, you're essentially betting on a company's success and hoping that its value will increase over time. However, investing in an IPO can be a complex endeavour, requiring a solid understanding of the key terms and concepts involved.
Just like learning a new language, familiarising yourself with the vocabulary of IPOs is crucial. So, let's delve into 10 essential terms that will serve as your compass on this thrilling investment path.
1. Initial public offering
Some of us might have decided to invest in a newly formed company but we might not be aware of the term - Initial Public Offering.
An Initial Public Offering (IPO) is like a grand opening for a company on the stock market. It's when a private company decides to sell its shares to the public for the first time. By doing this, the company allows regular people, like you and I, to become part-owners of the company by buying shares. The company sets a price for these shares, and you can invest in them for the first time ever.
2. Prospectus
You can think of a prospectus as a brochure of the company. Every company going for an IPO mandatorily provides a prospectus to its investors.
This serves as a comprehensive guide for potential investors, offering detailed information about the company's business, financials, risks, and future plans. The two types of prospectus that are generally given are:
- The abridged prospectus: As the name suggests, an abridged prospectus is a short version of the original prospectus. It presents the key information in a summarised and easily understandable format. This short prospectus is used to garner initial interest amongst the general public and encourages them to go through the complete prospectus for more comprehensive information.
- Draft Red Herring Prospectus (DRHP): The DRHP is a preliminary version of the prospectus filed with regulatory authorities, such as the Securities and Exchange Board of India (SEBI) in India or the Securities and Exchange Commission (SEC) in the United States. The term "red herring" refers to the disclaimer printed in red ink on the cover page, stating that the information provided in the document is subject to change.
3. Price Band
The price band in an IPO is like a price range set by the company for the shares it wants to sell to the public. The company does not decide on a fixed price. Instead, it gives the investors a range of prices with minimum and maximum prices helping investors decide if they want to buy the shares at that range.
However, the final price on which the shares are bought will be decided based on investor interest and market conditions. It gives both the company and investors some flexibility to find the right price that works for everyone.
4. Underwriters
Underwriters are a group of financial institutions that helps the company in the process of initial public offering. Underwriters work with the company to determine the appropriate price at which the securities will be offered to the public. This involves considering various factors such as market conditions, demand for the securities, and the company's financial performance.
Other responsibilities of underwriters include drafting the prospectus, marketing the offering to the public, managing the process of allocating shares to investors, etc. At times, they may also buy or sell shares to offset any excessive price fluctuations.
5. Market Capitalisation
Popularly known as market cap, this term means a measurement of the value of the trading company. It is calculated by multiplying the company's current share price by the total number of outstanding shares.
Market capitalisation tells people about the overall worth of the company in the market. Companies with a higher market capitalisation are generally considered larger and more established, while those with a lower market cap are usually smaller or newer companies.
6. Fair value
Fair value is the price at which the investors would like to buy the share from the company. In simpler terms, fair value represents what something is truly worth based on its characteristics, market conditions, and other relevant factors.
To determine the fair value of an asset, various methods can be used, such as comparing it to similar assets, analysing its income potential, or considering its replacement cost. The goal is to arrive at a price that reflects the true value of the asset, without any biases or distortions.
7. Liquidity
Liquidity can be explained as how easily an asset can be converted into other liquid forms like cash or other tradable assets. Investors often consider liquidity when making investment decisions. They may prefer more liquid assets if they anticipate needing quick access to cash or want the ability to buy or sell investments easily. But if an investor would like to go for long-term investments, then they may prefer less liquid assets to gain high returns in the long run.
8. Insiders
Insiders are those people who are closer to the source, in this context, insiders can be employees, managers, or executives of a company who have access to confidential information about the company's operations, financial situation, or future plans.
Insiders are able to know the inner workings, secrets, or upcoming events related to the companies which give them an edge over others.
9. Lock-up period
Lock-up period or lock-in period means the period during which the investors are not allowed to sell their shares to another person. It is a contractual agreement that prevents insiders, such as company executives, employees, or early investors, from selling their shares immediately after an initial public offering (IPO) or other significant events.
The lock-up period is imposed to maintain stability after the initial public offering. Generally, the lock-up period can range anywhere from 90 to 180 days depending on the company’s preference.
10. Securities and Exchange Board of India
The Securities and Exchange Board of India (SEBI) is a regulatory body for the capital market in India. It is responsible for protecting investors, and maintaining fair trades. SEBI regulates and oversees various participants in the securities industry, including securities exchanges, brokers, investment advisors, and mutual funds.
The main objective of SEBI is to ensure investors have access to accurate and timely information, prevent fraud and manipulation in the securities markets, and enforce securities laws to maintain market integrity. Any company that wants to go public must first be cleared by the SEBI.