The how, what, and whys of Initial Public Offerings (IPOs)

Every time that a company making an Initial Public Offering (IPO) enters into the news cycle, there is some confusion as to what exactly an IPO is and how it works. As the name suggests and one might intuitively guess, an IPO is when a private company decides to go public and offers people the opportunity to buy shares or stocks in it. 

But to understand the technicalities of this, one must know what stocks are exactly and how they work, as well as the different ways that one can participate in an IPO and the advantages and disadvantages that come with these different ways. Essentially, an IPO happens when a company is looking to gain capital and turns to the general public for it rather than getting a loan from a bank and increasing their debt. It usually means that a company is looking to expand and expand at a certain rate. 

However, in Pakistan, IPOs are not that common and a lot of family owned companies that have made it big (think Tapal or Shan) want to keep the business limited to themselves and shy away from going public. This is mostly due to the business culture in Pakistan, but if a large privately owned company in Pakistan wanted to raise some serious capital and go on an aggressive expansion project.

What are shares and stocks? 

Before we get into the details of what an IPO is, we need to begin with a very brief understanding of what a private company is, what shares are, what stocks are, and how the trade of these entities work. Essentially, any company is owned in shares between numerous people. Stock is all of the shares into which ownership of a corporation is divided. A single share of this overall ‘stock’ represents a fractional ownership of the company. 

The stock exchange is where you can buy and sell shares in publicly traded companies. As soon as you buy shares of stock on the stock market, you become a shareholder within the company by acquiring an ownership stake of the business. All publicly-traded companies have their equity split up in a great number of shares that are constantly switching owners throughout the day. So one question that you might ask yourself is: How many shares does a company have? 

The answer to this question depends. Since there is no restriction for the number of shares within a company, different types of companies can have varying numbers of existing shares. A start-up might only have a few shareholders, while multi-billion dollar companies will usually consist of millions or even billions of shares outstanding. Deciding on how many shares a company should start with, depends on the future growth potential of the company. Therefore, the number of shares is completely determined by the business and its owners.  

This is also where IPOs become important. You see when a company is privately owned, it may issue stock and have shareholders, but their shares do not trade on public exchanges. When these companies do want to go public, they offer shares in their stock through an initial public offering (IPO). Essentially, when a company wants to bring in capital they decide that they will offer shares at a certain price that the general public can then buy – meaning the number of shares that make up their overall stock increase. And since these new shareholders are bringing in money, the overall size of the stock also increases. The new shareholders will eventually get dividends based on the profits that the company makes. The goal is that the freshly raised capital through the selling of shares will allow the company to grow and thus make greater profits for everyone involved. 

Generally, a company can choose how many shares it chooses to have. Choosing a number depends on how big you expect your company to get and how much you think it will be worth it – a valuation the company has to make. Take for example an IPO that is made at around $10 per share value. If you estimate your company’s value to be $1 million at the IPO, then the number of authorized stocks should be 100,000. In the beginning, your business won’t be worth $1 million, so each stock won’t be worth $10. Each share may be worth pennies, but over time, its value will hopefully increase.

Once you’ve decided on your number, you want to decide how you’re going to issue stocks. A general formula that is at tims recommended is that startups should issue 60 percent of authorized stocks and reserve 40 percent for investing and stock options. The rest belongs to the founders of the company. You can keep more or less of your stocks for founders – that is up to the company. Many businesses have between 5 and 30 percent founder ownership at the company’s IPO.

The details of IPOs and who can invest

An IPO is the first time a company is able to sell securities to the public. IPOs are called Primary Markets. Their purpose is to bridge companies that need funds with investors. Now, there are different things that you can sell through an IPO. What we have been talking about up until now is selling equity in the company in the form of shares. However, you can also sell quasi equity as well as debt using an IPO.

What is interesting is that not only can you sell new shares through an IPO to raise capital, even though it is the most common, sometimes existing shareholders sell their shares through IPOs to liquidate their investment.

Now, technically anyone can invest in an IPO provided that they have a CNIC, a bank account at any commercial bank, a CDS account, an email address, and mobile phone number. You are treated as a single applicant and therefore can only make one application for at least the minimum number of shares mentioned in the prospectus.

A CDS account is an investor account with the CDC (Central Depositary Company) or a sub account with CDS participants. That means an account with a securities brokerage company or commercial bank. Under Section 72 of the Companies Act, 2017, companies are required to issue shares in the book-entry form only and therefore physical form of shares are a thing of the past. You can no longer trade physical shares. You need a CDS account to trade them if you’re holding on to old shares. Once you get shares through an IPO, they are credited to your CDS account.

How do I make an IPO? 

The company first chooses an investment bank to act as an advisor on the IPO and to provide underwriting services. This is where the company makes a valuation essentially, and decides how many shares they want to issue in their IPO. Now, you might think a company would want to keep the price high and the stocks few so they can keep control of the company and get more capital out of it. However, they also want to offer it at a price where people will bite … without it getting oversubscribed. We’ll explain oversubscription later, but as you can see it gets a little bit tricky here. 

Underwriting is when the investment bank acts as a broker between the issuing company and the investing public to help sell the initial set of shares. The underwriter is contractually bound to purchase the issue from the issuing company at a specific price. It later sells to the public. You could have one underwriter or multiple. However, in the case of multiple, one investment bank is chosen as the lead or the book-running manager.

The company then files a registration statement including the prospectus and private filling. The prospectus is issued so that anyone that is interested to invest in the company can read more about it. Following this, the road show begins. This is the phase in which the shares are marketed to institutional investors. Throughout this stage the demand for the shares is evaluated.

Once the IPO is approved by the regulator, in our case the SECP, an effective date is decided. The day before the effective date is important because that is when the issuing company and the underwriter decide the offer price and the number of shares to be sold. The offer price is the price at which the shares will be sold by the issuing company.

The offer price depends on how well investors received the roadshow pulled off, the plans of the business, and the conditions of the economy. This is what is known as the fixed price method.

The book building method is when the price is determined based on the Dutch auction method. A floor price is decided by the issuer. Institutional investors and high net-worth individual investors then make bids during the bidding process which can be seen on the PSX website. This helps determine demand. Following this a strike price is decided. Shares are then provisionally allotted to the successful bidders at the strike price determined through the book building process and then offers of shares to retail investors can be made at the strike price of less than it.

Once the company files for an IPO and its application gets approved, investors can subscribe to its shares within a given time period. This is usually between 3 to 10 days. During this period of IPO subscription, retail investors and others can subscribe for the company’s shares. 

There are three possible scenarios here- and IPO can be undersubscribed, fully subscribed or oversubscribed.

When an IPO is undersubscribed, it acts as a reflection of the lack of demand for the issuer company’s shares. In this case, most of the investors in the IPO subscription get as many lots of shares as they had applied for. However, what raises concern here is a lower-than-expected demand. This usually results in a crash in share price on the day of listing. When an IPO is fully subscribed, each investor simply gets the number of shares applied for. An IPO is said to be oversubscribed when the demand for shares exceeds the total number of shares on offer. This means that investors have applied for a greater number of share lots than what was put on offer by the company.

If an IPO is oversubscribed to such an extent that all investors cannot be allotted a minimum of one lot each, then the share lots are allotted to subscribers using a lottery system. In such a case, many subscribers may not be allotted any shares.

Then comes the stabilization period. This is when the underwriter is able to create a market for the issued stock. They can even purchase shares at the offering price or below it to stabilize the market. This is a short span of time when the underwriter has freedom to trade and influence the price of the issue given that price manipulation prohibitions are temporarily suspended.

The quiet period ends in 25 days and then the shares are listed on the stock market. No longer do investors rely on the prospectus. They now rely on market forces. The underwriter now puts on another hat, this time they’re an advisor and evaluator and help provide estimates on the earning and valuation of the company,

So how do I invest in an IPO?

There are three ways to invest in an IPO in Pakistan.

The old-school way is manually by filling out a form from your bank. All you need to do is go to a bank that is being used for the issue of shares, fill out the form and pay. You could also download this form from the PSX website, the consultant to the issuer and issuer website as well.

Another way is electronically through the Centralized e-IPO System CES. You’ve got to register with CES for this. All you need to do is go to www.cdcepio.com. You only need to register once and can participate in multiple IPOs through this account, given you make applications for each IPO. There is no fee for registration.

You could also fill an e-application through the link shared in the prospectus. Some banks such as UBL, Summit Bank and Bank Alfalah provide E-Ipo facilities to their account holders.

After closing of the subscription period, all the applications received are then sent for balloting and scrutiny. If you were unsuccessful with your application, you will get a refund into your bank account within a specified time period. However, if you are successful, shares will be credited into your CDS account within 10 days of the closing of the public subscription period. Later on, if you want to buy or sell shares once listed you can do so through your brokerage agent.