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Ask Mint | How do companies raise money through initial public offerings?

Ask Mint | How do companies raise money through initial public offerings?
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First Published: Mon, Dec 24 2007. 12 33 AM IST

Updated: Mon, Dec 24 2007. 12 33 AM IST
Can you imagine our movie theatres without any movies or our newspapers without any news? What would it be like to go to a theatre just to eat popcorn and to purchase a newspaper only to wrap up old shoes? Sounds ridiculous? Now try to imagine the existence of our stock markets without initial public offerings (IPOs). Can our stock markets exist without them? Sounds a bit confusing. Maybe our friends Jinny and Johnny can enlighten us about the role IPOs play in the stock markets.
Johnny: Santa Claus, Santa Claus where have you been? I’ve waited one whole year to get a trash bin!
Jinny: What happened Johnny? Why are you talking to yourself?
Johnny: I am complaining to Santa Claus for bringing a trash bin as this year’s Christmas gift. It seems he is running short of money. We may very well see him coming out with an IPO. What do you say?
Jinny: But what makes you think that anybody running short of money can come out with an IPO? You really need to know a few basic things about IPOs.
Johnny: I’d be happy if you would explain them to me.
Jinny: You might have heard that there are two types of companies: public and private. Ever wondered what’s the difference between the two? Well, a private company is formed by a small group of individuals for carrying out their business. The ownership of a private company remains confined to this group of individuals. Every owner of the company owns shares, which represent his percentage of ownership of the firm. As per law, a private company can have a minimum of two and a maximum of 50 owners. A public company must have a minimum of seven owners but there is no restriction on the maximum number. These owners contribute the capital of the company by purchasing its shares and take home whatever is their profit or loss. But, a company may require more money than its owners bring in as capital. If you have 50 owners and each of them contributes by purchasing 1,000 shares of Rs100 each, then you will have a capital of Rs50 lakh. But suppose tomorrow you need more money to expand your business. What options do you have?
JAYACHANDRAN / MINT
You can ask the owners to bring in more capital but beyond a limit, even that may not be possible. You can also approach a bank or a financial institution for a loan. This can work to a certain extent but taking a loan makes you liable to pay interest irrespective of what you earn. Beyond a point, even taking a loan may not work. After all this, you may consider offering ownership of your company to the public at large. But a private company can’t have more owners than what has been prescribed by law. The option of offering ownership to the public is only available to another class of company, which we call public companies. This entire process of raising money by offering subscription of shares of the company for the first time to the public is what we call initial public offerings or IPOs in short.
Johnny: I see! It seems an IPO enables a company to get its shares listed on the stock exchange where further trading takes place. Right?
Jinny: That’s right. Now let’s move further. This IPO can be done either by making a fresh issue of shares or by offering for sale the already existing shares or by a combination of both. Fresh issue of shares helps in expanding the capital whereas the sale of already existing shares enables the existing owner to dilute his shareholding. Once the company is listed after IPO, a follow-on public offering can also be made by the company to raise more money from the market. The company can also raise money by coming out with a rights issue. In a rights issue, new shares are offered to the existing shareholders as on the record date in a particular ratio to the number of shares already held. For instance, a ratio of one share for every five shares held will entitle a shareholder having 10 shares to acquire two new shares. This method enables a company to raise more money without diluting the stake of the existing shareholders.
Johnny: So, IPOs provide an easy way of raising money to all public companies.
Jinny: No. This alternative is available only to those companies that satisfy the eligibility criteria laid down by the market regulator, in our case, the Securities and Exchange Board of India.
The eligibility norms ensure that only companies meeting the desired level of standing are able to tap the market through IPOs. So the invitation is strictly on merit.
Johnny: Thanks Jinny. I will ask about the eligibility norms later. I think Santa is back. So, let’s celebrate. Merry Christmas!
What:Initial public offerings (IPOs) enable public companies to raise money through public subscription for the first time.
Where: After IPOs, companies get listed at stock exchanges where subsequent trading of shares takes place.
How: Companies can raise further money after listing through follow-on public offerings and rights issue.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
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First Published: Mon, Dec 24 2007. 12 33 AM IST