In an Initial Public Offer (IPO), private companies offer their equity shares to the public. IPO becomes an exit option for the existing investors (or existing shareholders). The issue price per share in an IPO is often much higher than the cost of shares held by the initial investors. In other words, public offers provide an opportunity for the original investors to gain by selling their shareholdings at a premium. At the same time, the IPO process also unlocks the firm’s value and true potential. We have earlier deliberated on whether should you invest in IPO or not, essentially focusing on the do and don’ts. Here, we delve deep into the risks and, therefore, the top seven reasons not to subscribe to IPOs. In other words, we elucidate why investors should not apply for an Initial Public Offer (IPO).
First, we will talk about the meaning of an Initial Public Offer (IPO). Second, focus on the reasons why any company opts to go for an IPO. Third, we will explore the risks associated with an IPO. And finally, conclude our note on why should investors not subscribe to IPOs. We believe this step by step approach will provide a proper context and help investors form their opinion.
What is an Initial Public Offer (IPO)?
IPO, Initial Public Offer, is when a privately held company becomes a publicly-traded company. In this process, the company offers its shares to the public. As an outcome, the number of shareholders increases from a handful to a few thousand or lakhs.
As a result of the IPO, the offering company also gets listed on the stock exchange. However, before a company desires its listing on a stock exchange, it must fulfil the eligibility criteria of the stock exchange. Here is the link to NSE’s eligibility criteria for your reference.
An Initial Public Offer provides an option to the existing shareholders to offer their shares to the public. The offer price per share to the public is higher than the cost per share paid by the original investors. But, this is quite obvious, as the early investors took the bet when the company was just an idea. The product, the team, etc., came subsequently. And, the company might have taken a long time to deliver any positive financial outcomes.
In other words, the early investors took a significantly high risk. Therefore, they expect better returns. However, this is just one of the outcomes. IPOs are also an opportunity to unlock the capital investment and get back their monies.
There are three kinds of offers during the IPO:
- Company issues fresh equity shares, and the IPO money funds a business objective
- The existing shareholders offer their shares (aka Offer For Sale). These include promotors, anchor investors, etc., who sell their shareholding during the IPO. Since there is no new share issuance, IPO leads to a change in the shareholding pattern
- A combination of the above two, where the company issues fresh shares along with an offer for sale by the existing shareholders
Why does a company offer an IPO?
Fundamentally, IPO is a money-raising process, and companies do it to expand their business, repay their loans, etc. There are several reasons why companies offer an IPO.
First, as we mentioned, the purpose of an IPO is to fund the firm’s growth. The company has successfully developed the product, identified the customer base, and firmed up expansion plans. The promoters have a limit to pump money into the business.
At this stage, the company needs money to fund expansion. A company can arrange for debt funds which are arguably cheaper but come with a fixed outflow. However, committing to an incremental fixed interest cost may seem unnecessary. Hence the need for an IPO.
Second, the company’s original investors may only be interested in investing for a specific duration. And the company is obligated to return their funds. One option is to bring in an investor (existing or new) to fund the cash and buy the seller’s stake. Another option is for the company to buy back its shares. This process drains money that the company can otherwise use to fund its growth. Here, an IPO comes to the rescue and provides an opportunity for the investors to exit.
Third, IPO is a matter of pride and significantly boosts brand visibility. In other words, listing on a stock exchange helps the company realize the brand’s actual value.
Finally, through an IPO, a company can invite investors to participate in the company’s growth. An IPO is the only way for retail, corporate and many other investors to become a part of the journey.
Risks of investing in an IPO
The first risk with having an IPO as a part of the asset allocation strategy is the chances of shares getting allotted. A set share allocation methodology decides which investor receives the shares, and in what proportion.
Recently we have observed a very high level of retail interest in the public offers. In other words, for a limited number of shares offered by the company, the number of shares applied is multifold. Therefore, a retail investor’s chances of getting the shares are minimal.
Second, investing in an IPO essentially means investing more on the pedigree of the promoters and less on the company. Why so? Because very few companies would have grown to such an extent that investors can assess the company separate from founders. Even for companies where the brand is solid, investors would rely on the lineage of anchor investors and promoters.
Third, usually, the IPO company would have existed for a limited time. Therefore, investors have to draw inferences from peers’ performance. Other aspects to consider are the sector’s future, past performance and expected growth. Of course, historical performances do not guarantee the company’s performance, but investors can draw valuable insights to appraise the investment.
Finally, the long-term success of an organization depends on the strength of its foundation. One of the foundational pillars is its corporate governance practices and sustainability measures. Unfortunately, it is difficult for the investors to figure out these aspects for new companies. The bottleneck is the low level of disclosures in the draft prospectus. Therefore, the investors have to take a chance and make a conscious choice based on company filings, but the risk exists.
You can read more about the future of sustainable investing in India here.
Here are top seven reasons not to subscribe to IPOs
First and foremost, one must decide whether to buy an IPO based on the overall personal investment strategy. In other words, whether to invest in an IPO or not should be an outcome of a well-defined approach.
Listed below are a few reasons justifying why we think you should not subscribe to an IPO.
An Initial Public Offer often acts as an exit route for promoters and the initial investors. So what? These early investors seek huge returns on their capital because they took a significantly high risk when they invested. Fair enough, but what is the point?
To compensate the initial investors, the issue price at which a company offers its shares is often too high. And, the offer at such a high-premium is the problem. Eventually, the share prices may not sustain at such levels. In conclusion, the subsequent reduction in the stock prices leads to capital erosion for retail investors.
Research shows that price discovery happens once the company is listed. In other words, post the listing, a time will come when the company is available at the proper valuation. However, essential to note that a fair price does not necessarily mean a price lower than the IPO price. It essentially means that market forces (demand and supply) have played their role to discover a fair price. At this level, the stock prices also reflect the confidence of market participants.
After a few weeks of price discovery, investors who wish to invest in a company can do so in the secondary market. Also, they can choose to wait and see the financial results for a few quarters before deciding to invest.
Pricing is a puzzle
IPO pricing is often a subject of debate, and the historical valuation methods cannot explain the issue price. In other words, the issue price is a puzzle, which only a select few can understand. Unfortunately, retail investors do not find a place amongst those and often fail to understand the offer price.
If the issuers’ price an IPO cheaply, they leave money on the table for investors gain. However, our common sense tells us that this is highly improbable. But, of course, this is unless the issuer is desperate to raise money from markets.
Even if we assume that the issuer cheaply priced their offer, the IPO will get listed at a premium. That is considering that business is fundamentally strong and sustainable. If such an IPOs lists at a premium, the subsequent ones will immediately get priced higher.
Valuation always matters. Investors must assess the extent to which issue price factors future growth potential. Any investment can be good and bad simultaneously. It all depends on the price.
Invest in growth, and that is the key. In many cases, investors thought IPOs to be expensive, but those stocks delivered multifold returns. What happened there? The company’s business model was robust, and the company witnessed significant growth. So, the key is the growth potential at the right price. However, this is easier said than done.
Risky asset class
When a company decides to come up with an IPO, there are inadequate resources to evaluate the true potential and worth of the organization.
The lack of information prohibits investors from assessing the organization’s fundamental strength. Therefore, retail investors with a low-risk tolerance should avoid investing in an IPO.
If you know a fundamentally strong company is coming up with an IPO at a correct price point, you can invest. But such in-depth knowledge is not widely available. Therefore, we believe that investing in an IPO is certainly a risky proposition.
Emotions outdo reasons
The launch of the IPO often coincides with the timing when the market is on a high. Bulls are making their mark, and the fear of missing out is playing hard on investors’ minds.
Retail investors often get swayed by popular consumer trends, and logic gets overridden. That is the worst way to make an investment decision and commit financial resources.
Above all, never chase the oversubscription numbers and do not let those swanky posters drive your decision. You risk investing in the artificial buzz created by the company.
The real world is outside
Although the company has existed, it is less exposed in multiple ways to the real world before IPO happens. These factors include but are not limited to compliance, financial reporting, valuation, analysts and the public at large as its investors, etc.
Investors should not look at IPO stocks differently from the shares already listed. Therefore, the investors must properly research the IPO company and choose the best investment.
Prices may tumble post the lock-in period
As per the SEBI guidelines, a lock-in period exists for anchor investors of 30 days for 50% of their shareholding. The lock-in is 90 days for the balance.
After that lock-in period, these investors can sell the shares. In the case of stocks that have experienced sharp price rallies, the end of the lock-in period is a chance to cash out and take the profits.
In case of a sell-off, the stock prices may witness a fall and erode the investor’s capital.
Highly unlikely to build wealth
There is a limit to the sum one can invest in an IPO. For retail investors, the limit is Rs 2 Lakhs in total and Rs 15,000 per application at the high end of pricing.
The more popular and over-subscribed the IPO is, the fewer the shares allocated to investors. In other words, usually, the total amount invested into an IPO is low or insignificant compared to the overall portfolio.
Therefore, even if one of the IPO investments becomes a multi-bagger, the chance of creating wealth out of it is considerably less. Above all, some of the IPOs might not perform well. Considering IPOs as a class of investment, the average performance of all your IPOs would be considerably low at an overall level. Especially when you compare returns adjusted for risk an investors take while investing in IPOs, returns would be meagre.
The bottom line
Equities are considered a risky asset and demand significant research about the company before making an investment decision. In addition, the initial public offer is an even more complex category within the equity asset class. Although IPO is an opportunity to invest in an organization’s future, due to many reasons, as discussed above, IPOs are indeed a high-risk investment option. Therefore, we believe investors with low to moderate risk tolerance should avoid this sub-category of equity investment.
Notwithstanding the above, the decision to apply for IPO is very subjective, and it depends on individual preferences. Moreover, the decision to participate in an IPO also depends upon the company’s prospects and the offer’s pricing. Therefore, we urge investors to assess risks (and opportunities) and then decide for themselves. There is no correct answer, or an incorrect choice, as every investment decision is a matter of perspective.
Above all, it is imperative to realize that one size does not fit all. The financial objectives, plans and investments are tailor-made to suit individual requirements. Feel free to meet your financial advisor to help you make the right investment decisions.
Happy selective investing!
About the author
The author is a senior finance professional with over fifteen years of work experience in corporate finance. He has an affinity for matters relating to personal finance and investment management. The author wants to share his knowledge and understanding of the subject through his writing.
The author has used his knowledge, experience, and understanding of the subject and has exercised extreme caution to avoid possible mistakes. However, the author does not take responsibility for any error that exists.
The article’s views, opinions, and thoughts belong solely to the author and not necessarily to the author’s employer (past or current), organization, committee, or other group or individual.
Under any circumstances, the author shall not be liable for any views or analysis expressed in this note. Further, the opinions expressed are not binding on any authority or Court. We advise readers to consult their financial advisor for assistance in their specific case.