Introduction to Share Market

Introduction to Share Market → Chapter 4 → IPO Market – Part 1 – Poonit Rathore

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4.1 Brief description

The first 3 chapters cover all the basic information that any investor should know about the stock market. Now at this stage, it becomes necessary to answer/know one question, and that question is – Why do companies bring IPO?

Understanding the answer to this question in the right way will make it much easier to understand the topics ahead. In this chapter, we will learn about some new financial concepts. 

4.2 Starting the Business

Before we answer the question of why companies bring IPO, we need to know and understand some basic concepts like how any company starts. Let’s understand this through a story, and divide this story into a few different scenes so that how the business and funding system works, how it builds and grows, is understood properly. Go 

Scene 1 – The Angels

Let’s say there is a businessman or an entrepreneur who has a great business idea. That business idea is to make and sell fashionable T-shirts made of organic cotton. The designs of these T-shirts will be unique, their prices will also be attractive for the customers and the best quality cotton will be used in their production. That entrepreneur is sure that this business will be successful and he is also very excited to convert this idea into a business. 

As is the case with other entrepreneurs, before doing anything he too will have one question – where will the money for this business come from? Suppose he does not even have experience in running a business. In such a situation, it is very difficult to find someone who will invest money in his idea. So what will he do? He will take help from his family, relatives, or friends. He can also apply for a loan from the bank but at this stage, it will not be a good option. 

Then let us assume that he invests his savings and at the same time persuades two of his friends to invest money in the business. The two friends are putting money into the business even before it starts making money, betting on the entrepreneur in a way. In such a situation, both these friends will be called Angel Investors. Here you should note that the money that angel investors invest is not a loan but an investment in the business.

Now assume that the promoter (who has the business idea) and the angel investors together add Rs 5 crore. This capital will be called “Seed Fund”. This seed fund is not kept in the bank account of the promoter but in the bank account of the company. As soon as this seed fund is deposited in the company’s bank account, this money is known as the initial share capital of the company.

In lieu of this seed investment, the three shareholders (promoter and 2 angel investors) are issued share certificates of the company, which shows that all three are the owners of the company or have ownership.

Right now the company has only Rs 5 crore, this is the asset of the company. Therefore the value of the company is also Rs.5 crore. This is called the valuation of the company. 

Issuing shares is very easy. The company assumes that the price of each share is Rs 10 and since there is a share capital of Rs 5 crore, there will be 50 lakh shares and the share price will be Rs 10. Here the share price of Rs 10 is called the face value of the share. The face value need not be Rs 10 only, it can be more or less. If the face value is Rs 5, then the number of shares will be 1 crore. 

The 50 lakh shares issued above are called Authorized Shares of the company. Some part of this is distributed among all three i.e. promoters and 2 angel investors, as well as some shares are kept with the company keeping in mind the future. 

Now assume that the promoter gets 40% of the shares, and both the angel investors get 5% each. 50% of shares were kept with the company. The shares received by the promoters and angel investors are called Issued Shares. 

The shareholding pattern of the company will be something like this…

NoName of shareholderNumber of sharesHolding (in %)
2Angel 1250,0005
3Angel 2250,0005

Remember that the remaining 50% is held by the company. These are authorized shares, but not allotted.

Now the promoter owns the company, and also a good seed fund. The promoter starts the business, but he takes it slow and opens a small manufacturing unit and just one retail store to make and sell his products. 

Scene 2 – The Venture Capitalist

The promoter’s hard work pays off and by the end of the second year, the company’s expenses and income become equal. When the expenses and income of the company are equal, then the company is said to be breaking even. The promoter also now has experience in running the company and is more confident than ever. Now the promoter wants to expand the business a bit. He plans to open one more manufacturing unit and some new retail stores. After making a business plan, he comes to know that the entire work will require a capital of Rs 7 crore. 

The condition of the promoter is very different now. There is continuous earning in the business. So the promoter can go to the investors who invest money in the new business. Let’s say he talks to one such investor who agrees to give him Rs 7 crore in exchange for a 14% stake in the company. 

Such investors who invest money in the initial years or phase of the business are called Venture capitalists (VC). The money that the company gets in this phase is called Series A funding. 

When the company allots 14% of the authorized capital to the VC, the shareholding pattern will be as follows…

NoName of share holderNumber of sharesHolding (in %)
2Angel 1250,0005
3Angel 2250,0005
4venture capitalist700,00014

Remember that the remaining 36% of shares are still held by the company and have not been issued. 

Now after VC money comes into the business a new thing is happening. The VC has given a valuation of 50 crores to the entire company by giving 7 crores for his 14% stake or share. This is 10 times more than the initial valuation of 5 crores. This is how business gets the benefit of a good business plan and good income. This is how business gets bigger. As the valuation of the company increases, the investment of early investors also gets affected, which you can understand from the table below. 

NoName of ShareholderInitial ShareholdingInitial ValuationShareholding after 2 yearsValuation after 2 yearsWealth Creation
1promoter40%2 crores40%200 million10 times
2Angel 15%25 lakhs5%2.5 crores10 times
3Angel 25%25 lakhs5%2.5 crores10 times
4venture capitalist0%THAT14%07 croresTHAT
gross50%2.5 crores64%32 crores

Get on with the story. The promoter now has the additional capital required to expand the business. The company got a new manufacturing unit and some retail outlets. Everything is going great. The popularity of the product is increasing, which is generating more income. The management team is getting better and better which is improving the operations and increasing the profits of the company. 

Scene 3: The Banker

3 more years passed. The company is touching on new dimensions of success. At this stage, the company decides to start retail stores in 3 more cities. And it is obvious that for this the company will have to increase the production capacity and also recruit new people. This type of expenditure, which is done by the company to grow and improve the business, is called capital expenditure or CAPEX. 

Management feels that Rs 40 crore will be required for this work. So the question arises that how will the company meet this need. 

There are a few options before the company adds this capital

  1. The CAPEX requirement can be met with the money that the company has earned in the last few years. This way is called internal accruals or raising money from internal sources. 
  2. The company can approach another VC and seek VC funding again. For this, he has to give shares to VC. This is called Series B funding. 
  3. The company can go to a bank and ask for a loan. Since the company is doing good business, it will not be difficult for the company to get a loan. 

The company adopted all the above three routes – 15 crores from internal sources, 10 crores by giving 5% equity in Series B, and took a loan of 15 crores from a bank. 

Note that due to getting 10 crores in exchange for 5% equity, the valuation of the company is visible at 200 crores. Maybe it’s a bit much, but for now, we’ll take it for the sake of the story. 

Now the shareholding and valuation of the company will look something like this…

NoName of share holderNumber of sharesHolding (in %)Valuation (in Rs crore)
2Angel 1250,000510
3Angel 2250,000510
4VC Series A700,0001428
5VC Series B250,000510

You will see that the company has not yet allotted 31% shares to any shareholder. The current value of these shares is Rs 62 crore. This is how a company’s capital grows, especially when an entrepreneur has a good business idea and a good management team. 

You will find such examples in Infosys, Page Industries, Eicher Motors, and internationally in Google, Facebook, Twitter, WhatsApp, etc. 

Scene 4 – The Private Equity (PE)

A few years pass and the company reaches new heights of success. With the success, this 8-year-old 200 crore company gets filled with more enthusiasm. The company now wants to expand its business across the country. The company now wants to set up its own factory and sell fashion accessories, designer cosmetics, and perfumes. 

For this new work, the company needs a CAPEX of 60 crores. The company does not want to take a loan because paying interest will reduce its profits. 

The company wants to take Series C funding by giving some more shares to the VC. But she cannot go to any normal or common VC because VC funding is available only for a few crores. Hence, now the company will have to approach a private equity investor. 

PE investors are very knowledgeable. He has vast experience. They invest huge amounts and also put their own people on the board of the company so that the company moves in a certain direction. Suppose he takes a 15% stake and pays Rs 60 crore for it. In this way, now the valuation of the company will reach 400 crores. Now let’s look at the shareholding and valuation of the company…

NoName of ShareholderNumber of SharesHolding (in %)Valuation (in Rs crore)
2Angel 1250,000520
3Angel 2250,000520
5VC B250,000520
6PE Series C7,50,0001560

Remember that the company still holds 16 percent which has not been allotted to anyone. Its price is now 64 crores. 

Usually, when a PE invests, it gives money for a large CAPEX requirement. PE never invests money in the initial stages of the business, rather it invests in companies that have been working for a few years and are earning. Taking money from PE and putting that money into CAPEX is a long-term exercise and takes a few years. 

Scene 5 – The IPO

After 5 years of PE investment, the business of the company has grown tremendously. They have added many products and are present in many big cities of the country. Earnings are doing well, profits are stable and investors are happy. But the promoter is not satisfied with this. The promoter now wants to expand the business overseas as well. He wants to have at least two outlets or shops in all the major cities of the world.

This means that now the company will have to research the markets of different countries to see what the people there like. The company will have to hire new people and also increase its production. Also, money will have to be spent on real estate all over the world. 

This time the CAPEX requirement is huge and the management estimates that it needs Rs 200 crore. The road ahead for the company

  1. Internal Accruals – Internal Sources
  2. Series D funding from the PE fund
  3. loan from bank 
  4. Issuing bonds (another form of debt)
  5. Issue of shares through IPO
  6. combination of all of the above

Suppose the company decides to raise some part of the CAPEX through internal accruals and the rest through an IPO. When the company brings an IPO, it sells its shares to the general public. Since the company is selling its shares to the public for the first time, it is called Initial Public Offer or IPO. Now some questions are bound to arise

  1. Why did the company decide to launch an IPO and why does the company take this route? 
  2. Why didn’t the company choose the IPO route at the time of Series A, B, and C earlier?
  3. What will happen to exist shareholders after the IPO? 
  4. What does the general public look for before investing money in an IPO? 
  5. How does this whole process of IPO proceed?
  6. Which financial intermediaries work in the IPO market?
  7. What happens when a company comes out with a public issue? 

In the next chapter, we will answer these questions and also tell you some other things related to the IPO market. Hope you have understood the journey till the company’s IPO.  

Important points of this chapter: 

  1. Before understanding why companies come to the stock market, it is more important to understand how companies are formed, and where and how they start.
  2. Those who invest in the business before the revenue or income comes, are called Angel Investors. 
  3. Angel investors bear the highest risk. It can be said that promoters and angel investors bear equal risks. 
  4. The capital that angel investors provide to start a business is called a seed fund. 
  5.  Angel investors invest less money than others.
  6. The valuation of the company tells how much the company is valued. The value of the company is calculated by taking into account the assets and liabilities of the company. 
  7. Face value represents the actual value of the share. 
  8. All the shares held by the company are called authorized shares. 
  9. Shares given out of authorized shares are called issued shares. 
  10. The shareholding pattern of a company tells us who holds how much in the company. 
  11. Venture capitalists invest in early-stage companies, so the risk they take is less than angel investors. The amount invested by a VC is usually somewhere between angel and private equity investing. 
  12. The money that the company spends on expanding or expanding the business is called capital expenditure or CAPEX. 
  13. As the company grows, it needs Series A, B, C, etc. funding. Generally, the higher the series, the higher the amount required
  14. Beyond this point, VCs cannot invest in the company. In such a situation, the company has to go to a private equity firm. 
  15. Private equity firms invest large capital and they usually invest after the initial phase of the business, when the business becomes a bit stable. 
  16. In terms of risk appetite, the risk appetite of a private equity firm is lower than that of VCs or angel investors. 
  17. Private equity firms want their own people to sit on the board of the company in which they invest so that the business runs in the right direction. 
  18. The valuation of the company increases with the growth in its business, income, and profits.
  19. The company can raise capital through the process of IPO. The company can use this capital for various purposes, such as CAPEX, debt restructuring, etc. 

Poonit Rathore

My name is Poonit Rathore. I am a Blogger, Content-writer, and Freelancer. Currently, I am pursuing my CMA final from ICAI. I live in India.

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