What is an IPO and How Does it Work: A Guide

Taking your company public through an Initial Public Offering (IPO) is one of the most impactful decisions you'll make in your business journey. 

It opens the door to significant capital, boosts your brand’s visibility, and provides liquidity for existing shareholders. 

However, it also introduces increased regulatory scrutiny, ongoing reporting requirements, and the need for a well-structured equity management system to handle shareholder communications, compliance, and corporate governance.

At EquityList, we simplify the transition to public markets by automating stock price updates for stakeholders, enforcing insider trading restrictions on employees, and anything else that you may need.

What is an IPO?

An Initial Public Offering (IPO) involves offering your company's shares to the public for the first time by listing it on a stock exchange. 

It allows the company to raise new capital from the public markets to expand, pay off debt, or fund other corporate initiatives.

It also offers a way for companies to provide liquidity to early investors and employees.

Preparation for IPO: How does the IPO process work? 

Going public through an IPO is a multi-step process that requires strategic planning, regulatory approvals, and financial readiness. 

Here’s how it works:

1. Financial statements, business plans, essential documents

Before moving forward with the IPO, ensure that these key documents are ready:

- Audited financial statements

- A solid business plan that outlines your company’s growth strategy and future goals.

- A well-defined and documented governance structure.

2. Hiring investment banks for underwriting and pricing

Investment banks are crucial for underwriting and pricing your IPO. When selecting one, consider:

- Firms with a history of successful IPOs, preferably in your industry.

- In-depth market analysis and guidance on IPO pricing.

- A firm that understands your sector to ensure accurate pricing and investor targeting.

The right investment bank will help ensure your IPO is properly priced and marketed to the right investors.

3. Regulatory filings and compliance

Both India and the U.S. have well-defined processes for their regulatory filings:

India: SEBI’s IPO regulatory process

In India, companies looking to go public must comply with regulations set by the Securities and Exchange Board of India (SEBI) and list their shares on stock exchanges like the NSE or BSE.

a. Filing the draft red herring prospectus (DRHP) with SEBI

Before launching an IPO, companies must submit a Draft Red Herring Prospectus (DRHP) to SEBI.

This document includes:

- The business model, operations, and financial history of the company.

- Audited financial statements, typically covering the past three years.

- A detailed disclosure of business and industry risks.

- Details on how the IPO funds will be utilized.

SEBI does not approve IPOs; instead, it provides observations. Companies must address SEBI’s feedback before proceeding with the IPO.

b. Preparing the final red herring prospectus (RHP)

Once SEBI’s observations are addressed, the company files the Red Herring Prospectus (RHP) with the registrar of companies (ROC).

c. Obtaining stock exchange approvals

Stock exchanges approve listing eligibility after the RHP is filed, allowing the IPO to proceed

United States: SEC’s IPO regulatory process

In the U.S., companies must follow the rules of the Securities and Exchange Commission (SEC) and list their shares on stock exchanges like the NYSE or NASDAQ.

a. Filing form S-1 (registration statement) with the SEC

The equivalent of India’s DRHP is the S-1 registration statement in the U.S., which contains almost the same information.

Like SEBI,  the SEC does not approve IPOs or pricing but rather reviews the filing to ensure full disclosure and  regulatory compliance.

b. SEC review and comments

The SEC reviews the S-1 and provides feedback. Companies must revise their filings until they meet all disclosure requirements.

c. Stock exchange listing process (NYSE/NASDAQ)

Parallel to the SEC process, the company must apply to list its shares on the NYSE or NASDAQ.

The exchange verifies whether the company meets financial and governance requirements, such as:

- Minimum revenue and profit thresholds.

- Corporate governance standards.

- Market capitalization and liquidity criteria.

If the company meets the criteria, it gets approval to list, but this is separate from the SEC's review.

4. Marketing through roadshows

During a roadshow, company executives, along with investment bankers, present the company’s financials, growth potential, and IPO details to institutional investors, fund managers, and analysts to generate demand.

5. Pricing the IPO

Setting the right IPO price is crucial for balancing investor demand and the company's fundraising goals. The price must be attractive enough to generate strong investor interest while ensuring the company raises sufficient capital without undervaluing itself.

There are two ways in which an IPO can be priced:

a. Fixed price method

In the fixed price method, a specific price is set for each share before the IPO is launched. Investors know the exact price at which they can purchase shares. This method provides certainty, but it doesn't allow for adjustments based on market demand.

Fixed price method is typically used for smaller IPOs.

b. Book building method

In the book building method, investors place bids within a price range (e.g., ₹500–₹550 or $25–$30 per share), and the final offer price is determined based on demand. 

This method provides more flexibility, as the final price reflects the investor interest and market conditions. It allows companies to gauge the appetite for their shares and adjust accordingly.

The book building method is typically used for larger IPOs.

5. Going public

This is the final step in the IPO process, where the company officially becomes publicly traded by listing its shares on a stock exchange.

The company selects an exchange (e.g., NSE/BSE in India or NYSE/NASDAQ in the U.S.) based on its growth strategy and investor base. Once approved, the stock exchange assigns a ticker symbol for the company’s shares.

If the IPO receives strong demand during the subscription period, especially from institutional investors, it can lead to oversubscription. 

Who sets the IPO Price?

The IPO price is determined collaboratively by the company and its underwriters. 

Factors such as the company's financial performance, prevailing market conditions, and anticipated investor demand are taken into account. Various valuation methods, including discounted cash flow analysis and comparisons to similar publicly traded companies, are used to arrive at an appropriate offering price. 

The goal is to set a price that reflects the company's intrinsic value while appealing to potential investors.

Understanding the need for IPOs

Going public through an Initial Public Offering (IPO) is a pivotal step for any business. It is a strategy for raising capital, enabling liquidity, and increasing market visibility. 

1. Raising capital for company growth and opportunities

While companies can continue to raise money from private markets for their growth, public markets provide access to a broader investor base, often allowing companies to raise significantly more capital than private funding rounds.

2. Enhancing brand visibility 

Going public increases a company’s visibility in the market, helping to build brand recognition. Additionally, a public listing signals stability and credibility, which can enhance investor and customer confidence.

3. Providing liquidity for existing shareholders

An IPO offers existing shareholders, such as early investors, employees with stock options, and founders, a way to liquidate their holdings. 

It provides an exit strategy for these stakeholders, allowing them to sell their shares on the open market. 

4. Establishing market value through demand and investor appetite

An IPO helps to establish a market value for the company by allowing public investors to determine what they are willing to pay for its equity. This process of price discovery, driven by investor demand, sets the public market value of the company. A successful IPO can significantly increase your company’s valuation, boosting credibility and investor confidence.

5. Accessing broader capital market options

Once you are publicly traded, the company gains easier access to the broader capital markets. This includes issuing additional shares in the future to raise more capital or accessing debt financing with potentially better terms. Being a public entity opens doors to various fundraising avenues, giving you flexibility and more options for long-term growth.

Publicly traded companies often have better borrowing power, which can significantly benefit the company’s financial health.

Pros & cons of IPO

Taking your company public through an Initial Public Offering (IPO) is a significant decision that comes with both advantages and challenges. Understanding these can help determine if an IPO aligns with your company's goals.

Pros

a. Access to capital

‍An IPO allows a company to raise substantial funds from public investors, providing capital to fuel growth, research and development, and expansion into new markets.

b. Enhanced public profile

‍Going public can increase your company's visibility and credibility, attracting new customers and business opportunities due to heightened media coverage and public awareness.

c. Liquidity for shareholders

‍An IPO offers an exit strategy for early investors and provides employees with the opportunity to liquidate their equity holdings. 

Cons

a. Regulatory compliance costs

‍Public companies must adhere to strict regulatory requirements, leading to significant ongoing expenses for legal, accounting, and compliance activities.

b. Loss of control

‍Issuing public shares dilutes existing ownership, potentially reducing control over company decisions as new shareholders gain voting rights.

c. Market pressures

‍Public companies face pressure to meet quarterly performance expectations, which directly impacts stock prices and can drive short-term decision-making.   

Post-IPO market activities

Several key activities follow after a company goes public:

1. Stabilization and after-market operations

Post-IPO, the company may experience price fluctuations and underwriters may have to step in to stabilize the stock by purchasing shares if needed, preventing significant drops below the offering price.

2. Lock-in period and insider restrictions

Company insiders, including founders,early investors and employees, are often subject to a lock-in period  restricting them from selling their shares immediately after the IPO. This helps prevent a sudden surge in supply that could negatively impact the stock price.

For employees specifically, you can place exercising restrictions on EquityList because they are most likely to be unaware of these nuances and make mistakes,

3. Quarterly earnings reports

As a publicly traded company, you must file quarterly and annual earnings reports with regulators (SEC in the U.S. and SEBI in India). These reports provide insights into financial performance and help maintain investor confidence.

Conclusion

The IPO process presents significant opportunities for businesses, allowing them to raise capital, enhance brand visibility, and provide liquidity to shareholders. By understanding how IPO works, companies can strategically position themselves for growth and gain access to broader capital markets. 

However, going public also comes with challenges, including regulatory compliance, market fluctuations, and the pressure to meet investor expectations.