The Basics Of Stock Market

Lesson -> The Initial Public Offer (IPO)- Part 01

4.1 The Overview

These three chapters provide background information on the fundamental market concepts that you will need to be familiar with. At this point, it is imperative to answer a fundamental question: Why do companies go public.

This topic is essential to a solid foundation for any future topics. This chapter will teach us new financial concepts.

4.2 The Origin of a Business

Before we move on to the question of why companies go public, let's first understand a basic concept: what is the origins and structure of a typical business. We will create a story to better understand this concept. To get a better understanding of the evolution of the business and funding environment, let's break this story down into multiple scenes.

Scene 1: The Angels

Imagine a budding entrepreneur who has a brilliant business idea: to make high-fashion, organic cotton T-shirts. These t-shirts are distinctive, have attractive prices, and only the highest quality cotton is used. He is optimistic that the business will succeed and is excited about the possibility of launching it as a business.

A typical entrepreneur will be faced with the problem of where to get the money to finance his idea. If the entrepreneur doesn't have any business experience, it is unlikely that he will attract serious investors at the beginning stage. He would likely approach his family and friends to pitch his idea and raise money. Although he could approach the bank to get a loan, this wouldn't be the best option.

Let's say that he pooled his money and convinced two of his friends to invest in the business. They are both investing in pre-revenue and making a blind wager on the entrepreneur known as the Angel investors.It is important to note that the money received from angels is not a loan. They have made an investment.

Let's say that the promoter raises capital of INR 5 crore with the help of the angels. The initial capital he receives to kick-start his business is called"The Seed Fund". Important to remember that the seed capital will not be held in the promoter's personal bank account, but in the company's bank account. The seed capital will be referred as the company’s initial capital once it has been deposited in the bank account.Share capital.

The original three investors (promoter and 2 angels) will receive share certificates, which give them access to the company.

At this point, the company only has INR 5 crores of cash. The company's total value is INR 5 crores. This is the company's "stash".Valuation

It is very simple to issue shares. The company assumes each share is worth at least Rs.10, and since there is Rs.5 Crore as share capital, there must be 50 million shares for each share worth Rs.10. The share's face value is Rs.10. Any number could be used as the face value. If the FV was Rs.5, the number of shares would then be 1 crore.

The total number of shares in the is 50 lakh Authorized shares of the company. These shares must be divided amongst the promoter and two angels. The company also has to keep some shares for future issues.

Let's say that the promoter keeps 40% of the shares and the two angels each get 5%. The company still retains 50%. This is the allotted share, which the promoter and the two angels each own 50%.Issued shares.

This is the shareholding pattern for this company:

Sl NoName of Share HolderNo of Shares%Holding
2Angel 1250,00005%
3Angel 2250,00005%

Scene 2 - Venture Capitalist

The business begins to recover from his hard work. The company begins to break even after two years. The promoter is no longer a novice business owner. He is now more familiar with his business and, of course, more confident.

The promoter is confident and wants to expand his business with 1 more manufacturing unit, as well as a few retail stores. He draws up the plan and calculates that the new investment required for his business expansion will be INR 7 crore.

He is in a much better place now than he was two years ago. His business is now generating revenue. This is a big difference. A steady inflow of revenue is a validation of the business and its offerings. He now has the opportunity to access reasonably smart investors to invest in his business. Let's say he meets a professional investor who offers him 7 crores in exchange for a 14% share of his company.

Investors who invest in the earliest stages of a business are called venture capitalist (VC)This is where the business receives the most money. Series A Finance.

The following shareholding pattern is possible after the company agrees that 14% of the authorized capital will be allotted to the VC:

Sl NoName of Share HolderNo of Shares%Holding
2Angel 1250,00005%
3Angel 2250,00005%
4Venture Capitalist700,00014%

The remaining 36% of shares are still held within the company. They have not been issued.

A significant development occurred with the infusion of VC money into the business. The entire business is valued at INR 50 Crs. He also values his 14% share at INR 7Crs. The initial valuation of 5Crs represents a 10 fold increase to the company's value. This is the impact a solid business plan and a steady revenue stream can have on businesses. It is a great recipe for wealth creationThe initial investors' investments will make a difference as the market values rise. 
This table summarises the same.

Sl NoName of Share HolderInitial ShareholdingInitial ValuationShareholding after 2 Yrs`Valuation after 2 YrsWealth Created
1Promoter40%2 Cr40%20 Cr10 times
2Angel 105%25 Lakhs05%2.5 Cr10 times
3Angel 205%25 Lakhs05%2.5 Cr10 times
4Venture Capitalist0%-NA-14%07 Cr-NA-
 Total50%2.5 Cr64%32 Cr 

Moving forward, the promoter now has all the capital he needs to run the business. As planned, the company receives an additional manufacturing unit as well as a few additional retail outlets. The product is gaining popularity, which leads to higher revenues. The management team becomes more professional which results in higher operational efficiency and better profits.

Scene 3 - The Banker

The company continues to grow and prosper for three more years. The company plans to establish a retail presence at least in three more cities. The company plans to expand its production capacity and hire additional resources in support of the retail presence in three more cities. When a company plans to spend such money to improve its overall business, it is known as 'Capital Expenditure'.'CAPEX.

Management estimates that 40Crs will be used to fund their CAPEX needs. How can the company raise this money, or in other words, how does it fund its CAPEX needs?

The company has few options to raise the funds they need for their CAPEX.

  1. Profits have been made by the company in the past few years. This can be used to fund a portion of the CAPEX requirements. This is also known as funding through.Internal accruals
  2. A company can approach another VC to raise additional VC funding. This is known as allocating shares from authorized capital.Series B funding.
  3. A bank can be approached by the company to provide a loan. Because the company is doing well, the bank will be willing to lend this loan. Also known as"Debt.

To raise capital for Capex, the company chooses to use all three options available to it. It borrows 15Crs internally, plans a series A - it divests 5% equity in exchange for 10Crs from another VC.

The company now has a valuation of 200 Crs, thanks to 10Crs being received for 5%. Although this may sound exaggerated at first glance, the purpose of the story is to convey the concept.

This is how the shareholding and valuation look like:

Sl NoName of Share HolderNo of Shares%HoldingValuation
1Promoter2,000,00040%80 Cr
2Angel 1250,00005%10 Cr
3Angel 2250,00005%10 Cr
4Venture Capitalist A700,00014%28 Cr
5Venture Capitalist B250,00005%10 Cr

The company has 31% shares that have not been allocated to shareholders. It is now valued at 62 Crs. You should also consider the wealth created over the years. This is what entrepreneurs who have great business ideas and a competent management team can achieve.

Infosys and Page Industries are classic examples of wealth creation stories. Eicher Motors, Titan Industries and Titan Industries are some other examples.

Scene 4 - Private Equity

Despite the passing of a few years, the company's success shines on. The ambitions of this 200 cr company, 8 years old, are growing. The company decides that it will raise the bar and expand its operations across the country. They decide to diversify their company by selling fashion accessories, cosmetics, and perfumes.
Note that the company retained a 16% share which was not allocated to any shareholder. This part is worth 64 Crs.

PEs usually invest to finance large CAPEX needs. They don't invest in businesses at the beginning of their development. Instead, they invest in companies with a steady revenue stream and have been in business for several years. It takes a while to deploy the PE capital and use the capital for the CAPEX needs.

CAPEX requirements for the new ambition are now set at 60 Crs. Due to the high interest rate burden (also known as the "Interest Rate Burden"), the company doesn't want to borrow money.Finance ChargesThis would reduce the company's profit.

They choose to allot shares of the authorized capital for Series C funding. Because VC funding is typically small, they cannot approach a typical VC. This is where a private Equity (PE). Investors are now part of the picture

PE investors are very savvy. They are highly skilled and have a strong professional background. They invest substantial amounts of money in order to make the capital productive and they also serve as directors of the invested company.

They now value the company at 400Crs if they buy a 15% stake in exchange for 60Crs. Let's take a look at the shareholdings and valuations.

Sl NoName of Share HolderNo of Shares%HoldingValuation (in CRS)
2Angel 1250,00005%20
3Angel 2250,00005%20
4Venture Capitalist A700,00014%56
5Venture Capitalist B250,00005%20
6PE Series C7,50,00015%60

Scene 5 - The IPO

The company has made great strides in 5 years since the PE investment. They have successfully diversified their product portfolio and are present in all major cities across the country. The investors are happy, their revenues are high, and profitability is stable. However, the promoter is not content with this.

Now, the promoter wants to be international. He would like his brand to be accessible in all major international cities. He also wants at least two outlets for each major city.

The company must invest in market research in order to understand the preferences of people in other countries and invest in people to increase their manufacturing capabilities. They also need to invest globally in real estate.

The CAPEX requirements are huge this time, with the management estimating that it will cost 200 Crs. The company is limited in its options for funding the CAPEX requirements.

  1. Internal accruals fund the Fund Capex
  2. Raise Series D from an alternative PE fund
  3. Bankers should raise the debt
  4. Float a Bond (this is another way to raise debt).
  5. By allocating shares from authorized capital, you can file for an Initial Public Offering (IPO).
  6. Combination of all of the above

Let's say that the company decides to finance the CAPEX partially through internal accruals. Then, they file for an IPO. A company must offer its shares to the public when they file for an IPO. The shares will be available for purchase by the general public (i.e. If they wish to, they can subscribe by paying a price. The company is now offering shares to the public for the first time."Initial Public Offering".

We now stand at an extremely crucial juncture where we need to answer a few questions.

  1. What made the company file for an IPO? Why do companies go public in general?
  2. Why didn't they file for the IPO while they were in Series A or B?
  3. What happens to exist shareholders following the IPO?
  4. What should the general public be looking for before signing up for the IPO?
  5. What is the evolution of the IPO process?
  6. Which financial intermediaries are involved in the IPO market?
  7. What happens when the company goes public?

We will answer each question plus give you more insight into the IPO market in the next chapter. You should now have a better understanding of the evolution of a successful company before they open their shares to the public. This chapter aims at giving you a complete understanding of the IPO market.

To Summerize

  1. Understanding the business' origin is crucial before understanding why companies go public.
  2. Angel Investors are people who invest in your company in its pre-revenue phase.
  3. Angel investors are willing to take on the greatest risk. They are as risk-averse as the promoter.
  4. The seed fund is the money angels give to start a business.
  5. Angels only invest a small amount.
  6. The company's value simply indicates how much it is worth. One values a company by looking at its assets and liabilities.
  7. Face value simply indicates how much a share was originally worth.
  8. The authorized shares of the company represent the total shares available to the company.
  9. The authorized shares are the shares that have been distributed. The authorized shares that are issued share a subset.
  10. A company's shareholding pattern tells us how much of the company's stock each person owns.
  11. Venture capitalists invest in the early stages of a business and do not have to risk Angel investors. VCs typically invest in a range between private equity and angel investments.
  12. Capital expenditure, also known as CAPEX, is the amount of money that a company spends to expand its business.
  13. As the company develops, they will need funding in Series A, B, C, etc. The investment requirement is usually higher for series that are higher.
  14. VCs can't invest beyond a certain amount, so companies looking for investments will need to approach Private Equity firms.
  15. PE firms typically invest in large amounts of money at an earlier stage of a business.
  16. PE's are more open to risk than angels or VC, but they have a lower risk appetite.
  17. PE investors are likely to want to have their own board members to help ensure that the business moves in the right direction.
  18. As the company's revenues, profitability, and valuation increase, the value of the company will also rise.
  19. An IPO is a way for a company to raise funds. Funds can be raised for any reason, including CAPEX, restructuring debt, or rewarding shareholders.