What is an IPO?

The Initial Public Offering or IPO holds the distinction as one of the few terms that has made the transition from the world of investment banking to the common man’s vocabulary.

An IPO is the first offering of a company’s shares (also known as stock or equity) to the general public. Most companies are structured in a way that ownership is determined by holding shares. Shares can be seen as small slices of a company and therefore it’s earnings. So when a person holds a share of a company (a shareholder) he is effectively part owner of that company. Companies are usually started by entrepreneurs who initially own the entire shareholding and then raise money by offering shares to investors. This is one of the most popular ways to raise funds for companies that are mature and well established.

So, to illustrate, initally the shareholding of a new company looks like this:

After the founder raises money:

Notice that the total number of shares of that company have now increased to 125 and the investor owns 25/125 which is 20% of the company.

An IPO is an extension of this concept. Instead of a single investor, a large group of investors invests in the company and shares are issued to them. This group includes retail investors (small investors like you and me), institutional investors (large mutual funds, banks etc), High Net Worth Investors (HNIs - basically rich people) all of whom invest in the company and receive shares for the cash that we give the company.

These shares then get listed (traded, quoted) on a stock exchange and can be freely traded. Once a company is listed, its value is determined by the number of outstanding shares (the 200 total shares mentioned above) times the price per share. This value is called the Market Capitalization or Market Cap.

The upside of an IPO is that it usually allows companies to raise far more money than through a private investor. For investors, the fact that shares are freely tradable means that they can sell out at any time (this ability is called liquidity of shares). The downside is that since the shares are being offered to the common public, the level of control over the company by regulatory authorities (SEBI in India) is hugely increased to ensure that unsophisticated investors can be fully informed of the company’s status, unlike in a private company where investors are considered sophisticated and the oversight by authorities is much lower.

Hopefully this provides you with some insight on what an IPO is and how it works. We will continue the basics of fundraising as a series.

Tagged as: capital markets, fundraising, initial public offering, ipo, venture capital