Part I: How to make money in IPOs

Everyone is talking about IPOs and the money that can be made through them. Here are a few terms you must understand if you plan to jump into the IPO arena.

In How to make money in IPOs, we explained what an Initial Public Offering is. Here we tackle the other terms.

The process

Book building is the process of price discovery.

The company does not come out with a fixed price for its shares; instead, it indicates a price band that mentions the lowest (referred to as the floor) and the highest (the cap) prices at which a share can be sold.

Bids are then invited for the shares. Each investor states how many shares s/he wants and what s/he is willing to pay for those shares (depending on the price band).

The actual price is then discovered based on these bids. As we continue with the series, we will explain the process in detail.

According to the book building process, three classes of investors can bid for the shares:

1. Qualified Institutional Buyers: Mutual funds and Foreign Institutional Investors. 

2. Retail investors: Anyone who bids for shares under Rs 50,000 is a retail investor. 

3. High net worth individuals and employees of the company.

Allotment is the process whereby those who apply are given (alloted) shares.

The bids are first allotted to the different categories and the over-subscription (more shares applied for than shares available) in each category is determined.

Retail investors and high net worth individuals get allotments on a proportional basis.

Assuming you are a retail investor and have applied for 200 shares in the issue, and the issue is over-subscribed five times in the retail category, you qualify to get 40 shares (200 shares/5).

Sometimes, the over-subscription is huge or the issue is priced so high that you can't really bid for too many shares before the Rs 50,000 limit is reached.

In such cases, allotments are made on the basis of a lottery.

Say, a retail investor has applied for five shares in an issue, and the retail category has been over-subscribed 10 times. The investor is entitled to half a share.

Since that isn't possible, it may then be decided that every 1 in 2 retail investors will get allotment. The investors are then selected by lottery and the issue allotted on a proportional basis.

That is why there is no way you can be sure of getting an allotment.

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The documents

A company coming out with a public issue has to come out with an Offer Document/ Prospectus.

An offer document is the document that contains all the information you need about the company. It will tell you why the company is coming is out with a public issue, its financials and how the issue will be priced.

The Draft Offer Document is the offer document in the draft stage.

Any company making a public issue is required to file the draft offer document with the Securities and Exchange Board of India, the market regulator.

If SEBI demands any changes, they have to be made. Once the changes are made, it is filed with the Registrar of Companies or the Stock Exchange.

It must be filed with SEBI at least 21 days before the company files it with the RoC/ Stock Exchange.

During this period, you can check it out on the SEBI Web site.

Red Herring Prospectus is just like the above, except that it will have all the information as a draft offer document; it will, however, not have the details of the price or the number of shares being offered or the amount of issue.

That is because the Red Herring Prospectus is used in book building issues only, where the details of the final price are known only after bidding is concluded.

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The players

Just because the prospectus has been filed with SEBI, it doesn't mean it recommends the issue or guarantees its contents.

That responsibility rests with the lead managers to the issue, who are supposed to do due diligence on the issue. In plain language, that means lead managers have to ensure the company is following the rules laid down for an IPO, that it has made available all the information a potential investor needs to know and that the facts in the prospectus are correct.

They are also called merchant bankers and are in charge of the issue process. They act as intermediaries between the company and the investors. They are also responsible for drawing up the prospectus and marketing the issue.

If it is a book building process, the lead manager also helps determine the price band; in such cases, they are also called Book Running Lead Managers.

Post issue activities, like intimation of allotments and refunds, are their responsibility as well.

The actual work of drawing up the list of allottees, crediting the shares to their demat accounts and ensuring refunds (if you are not alloted the shares, your money is returned to you within a month) is done by the Registrar to the Issue. This is a financial institution appointed to keep a record of the issue and ownership of company shares.

In the case of complaints like non-receipts of shares or refunds, investors must complain to the lead managers, who take up the matter with the registrars.

The names of all the lead managers and the registrar to the issue, with their addresses, phone numbers and e-mail addresses, are displayed prominently on the cover of every prospectus.

An Underwriter to the issue could be a banker, broker, merchant banker or a financial institution. They give a commitment to underwrite the issue.

Underwriting means they will subscribe to the balance shares if all the shares offered at the IPO are not picked up.

Suppose there is an issue is for Rs 100 crore (Rs 1 billion) and subscriptions are received only for Rs 80 crore (Rs 800 million). It is then left to the underwriters to pick up the balance Rs 20 crore (Rs 200 million).

If underwriters don't pay up, SEBI will cancel their licenses.

The decision

IPOs are nothing but stocks, which are a risky investment with no guarantees.

The lead manager may have certified that the facts, as disclosed in the prospectus, are correct. Prominent financial institutions may agree to underwrite the issue. The issue may even end up being oversubscribed.

That still does not mean it is meant for you. In our next article, we explain how to make sure you are buying an IPO at the right price.

Part I: How to make money in IPOs