IPO and Rights Issue

What is an IPO in the Share Market?

An Initial Public Offering (IPO) is the process by which a private company offers its shares to the public for the first time. For investors, an IPO is the first chance to purchase shares of the company. When the IPO are listed on a stock exchange, it becomes available for trading in the open market.

Key Aspects of an IPO:

1. Raising Capital:  A company decides to launch an IPO  to raise capital. The funds generated from the sale of shares in the IPO are typically used for business expansion, paying off debts, or investing in new projects.
2. Ownership Stake:  The company allows outside investors to become partial owners by offering shares to the public. It simply means that the ownership of the company is divided into shares, and the investors can buy and sell these shares on the stock exchange.

Why Do Companies Go Public?

1. Raise Capital: When companies need funds to grow, they often turn to public offerings, such as an Initial Public Offering (IPO). The funds raised can be used to expand into new markets, develop innovative products, or increase production capacity. If a company has existing loans or financial liabilities, the funds raised through an IPO can be used to reduce or eliminate debt. 
2. Enhance Credibility: Public companies often gain more visibility and trust among customers and investors.  Being publicly listed signals stability, transparency, and long-term viability to customers, investors, and stakeholders. Regular audits and disclosures required for public companies improve investor confidence, which can lead to easier access to additional funding in the future.
3. Liquidity for Shareholders: An IPO provides an opportunity for early investors  to sell some of their shares to realize profits.  Once shares are listed, they can be freely traded on the stock exchange, giving shareholders the option to sell their shares whenever they choose.
4. Attract and Retain Talent: Public companies can offer stock options to attract skilled workers. Stock options or equity compensation as part of the employee benefits package aligns employees’ interests with the company’s performance and motivates them to work towards its success. Stock options are often vested over a period, encouraging employees to stay with the company longer.

Process of an IPO:

1- Pre-IPO Planning: The company and its financial advisors prepare for the IPO, which includes evaluating the company's financial health, setting an appropriate share price, and preparing all required documentation.

2-Filing and Approval: The company submits a prospectus (detailed document outlining business, risks, and financials) and regulatory authorities [such as the Securities and Exchange Commission (SEC) in the U.S. or the SEBI (Securities and Exchange Board of India) in India] review it and approve the offering.

3-Pricing: Underwriters determine the offer price (price per share) and the number of shares to be issued. Pricing is based on the company’s valuation and expected investor demand.

4-Marketing: The company and underwriters put up the IPO to institutional investors to generate interest.

5-Listing: Once shares  IPO is launched, the shares are made available to the public. Investors can purchase shares during the offering, and the company raises the capital.

6-Trading Begins: After the IPO, the shares are listed on a stock exchange, and they begin trading in the secondary market, where their price fluctuates based on demand and supply.

Key Terms Related to IPOs

• Underwriter: Investment banks or financial institutions that manage the IPO process, including pricing and selling shares.
• Prospectus: A formal document detailing the company's business, financials, and risks, given to potential investors.
• Offer Price: The price at which shares are sold to investors during the IPO.
• Lock-Up Period: A period (typically 90–180 days) during which insiders and early investors cannot sell their shares after the IPO.
• Oversubscription: When demand for shares exceeds the supply, indicating high investor interest.

Benefits of an IPO:

• Access to Capital: The company can raise large amounts of funds for company's growth or reducing debt.
• Increased Public Profile: Being listed on a stock exchange increases the company’s visibility, which can help it attract customers, employees, and business partners.
• Liquidity for Shareholders: Shareholders, including the company’s founders and early investors, can sell their shares, to realize their investment gains.

Opportunities and Risks for Investors:

Opportunities:

• Potential for High Returns: IPOs of promising companies can lead to significant gains. IPOs often offer shares at an attractive price to encourage participation from institutional and retail investors. If the company's market valuation increases after listing, early investors can sell their shares at a good profit.
• Early Access: An IPO provides an opportunity to invest in a company at its earliest public stage, before it potentially grows larger and more valuable.  Investing early can be advantageous for long-term investors if the company’s vision and business model is good. If the company grows consistently, its share price may rise significantly over time.

Risks:

• Volatility: Newly listed stocks can experience significant price swings. Since the stock is new to the market, there’s no historical trading pattern to guide investors, which makes the price more susceptible to fluctuations.
• Uncertainty: Limited historical financial data makes it harder to evaluate the company. Investors primarily depend on the company’s IPO prospectus, which may not always provide a complete picture of the company’s challenges or risks.
• Overvaluation: Companies often promote their IPOs heavily to attract investors, creating a buzz that can inflate demand and drive up the initial offer price.

Thus, an IPO plays a significant role for a company to raise funds for company's growth. For investors, IPOs offer an opportunity to invest in a company at an early stage, although it also comes with risks and uncertainties.

What is a Rights Issue?

When a company offers its existing shareholders the chance to buy more shares at a lower price than the current market rate, it is called a Rights Issue. Shareholders can buy these shares based on how many they already own, but it depends on their choice, they are not forced to buy them.

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Key Features of a Rights Issue:

1. Offered to Existing Shareholders:
   Only current shareholders are eligible to purchase the rights issue. It gives a priority to existing shareholders to increase their ownership stake.
2. Proportionate Offering:
   The number of shares offered to each shareholder is proportional to the number of shares they already own.
   For example, a company might announce a 2:6 rights issue, it means for every 6 shares a shareholder currently own, are entitled to buy 2 new shares.
3. Discounted Price:
   The shares offered in a rights issue are generally at a lower price than the current market price to make the offer attractive to the existing shareholders.
4. Optional Participation:
   Shareholders are not mandatory to participate in it. They can choose to:
• Enjoy their rights and purchase the shares.
• Sell their rights to another investor (if the rights are transferable).
• They can ignore the offer.
5. Time-Bound Offer:
   A rights issue is open for a specific period, during which shareholders must decide whether to accept, sell, or forgo their rights.

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Why Do Companies Launch Rights Issues?

Companies launch rights issues to raise capital for various reasons, such as:

1. Debt Reduction:  Companies may use the funds raised from a rights issue to repay loans or debts:

·   Lower Financial Burden: Repaying debts reduces interest expenses, improving profitability and cash flow.

·   Improved Credit Profile: Reducing debt increases the company’s creditworthiness, and makes it easier to secure better terms for future borrowing if needed.

·   Risk Reduction: A high debt-to-equity ratio can be risky during economic downturns. That’s why Lowering debt helps the company become more financially stable.

 

2. Business Expansion: Funds from a rights issue can be used to grow the business by launching new projects, or building new facilities, or entering in the  new markets.

·    Increased Revenue Potential: Expanding operations in the business often leads to higher sales and profitability in the long run.

·    Competitiveness: If a company wants to get success in the market, it requires constant innovation, expansion, and investment.

·    Strategic Growth: Businesses often need additional capital to avail new opportunities quickly.

3. Working Capital Needs: Working capital refers to the fund required for daily business operations, such as paying salaries, purchasing raw materials, and managing inventory. It is important for:

• Operational Continuity: Ensures the business runs smoothly without interruptions caused by cash flow shortages.
• Short-Term Stability: Helps the company to deal with temporary financial challenges, such as unexpected expenses or a downturn in revenue.
• Supplier Relationships: Maintaining a healthy working capital ensures timely payments to suppliers, preserving good relationships.

4. Financial Stability: A rights issue helps to stabilize the company’s finances by strengthening its equity base in uncertain economic conditions.

• Buffer Against Losses: A stronger equity base can absorb losses and keep the company survive during tough times.
• Investor Confidence: Raising funds through a rights issue shows the company is taking timely action to manage its financial needs, which can build confidence among stakeholders.
• Improved Resilience: Stronger finances help the company handle economic challenges more effectively.
• Mergers and Acquisitions: Rights issues are often used to finance the purchase of another company or to merge with a strategic partner. Acquiring another company can provide access to new markets, products, or technologies. Mergers often result in cost savings, enhanced efficiency, and increased revenue.

 

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Advantages of a Rights Issue:

For Companies:

1. Efficient Fund raising: Rights issue allows companies to raise funds directly from existing shareholders.

·        The company avoids relying on external sources like loans or bonds.

·        It reduces the need for extensive marketing or public roadshows required for other fundraising methods.

·        Existing shareholders are more likely to support the fundraising effort since they already have a stake in the company.

2. Cost-Effective: The cost of conducting a rights issue is lower compared to other fundraising methods.

· No high interest payments, as in loans or bonds.

•     Limited administrative and regulatory expenses compared to a public offering.
•     Since the offer is only made to existing shareholders, advertising and underwriting costs are reduced.

3. Preserves Ownership: A rights issue prioritizes existing shareholders, avoiding the immediate need to bring in new investors.

· Share ownership remains within the existing group of shareholders.

· The company avoids diluting control by issuing shares to the public or external parties initially.

· This is especially valuable for companies that want to maintain ownership concentration or avoid hostile takeovers.

For Shareholders:

1-Discounted Shares

Shareholders get the opportunity to buy additional shares at a price lower than the current market rate.

·   It is a cost-effective way to increase their stake in the company.

·   If the market price remains stable or rises, the discounted shares offer an immediate financial gain.

·   This discount works as an incentive for shareholders to participate.

2. Maintains Ownership

Participating in a rights issue allows shareholders to maintain their ownership percentage in the company:

·  If shareholders buy the new shares proportionally to their existing holdings, their share of ownership and voting rights remains unchanged

·  This is particularly important in situations where shareholders want to retain influence over company decisions.

3. Trading Opportunity

If the rights are transferable, shareholders can sell their rights to other investors:

 ·   Shareholders who don’t want to invest further, can still get benefit financially by selling their rights.

·   Selling the rights gives shareholders a way to profit without spending additional money.

 

Disadvantages of a Rights Issue:

For Companies:

1. Limited to Existing Shareholders: Rights issue is limited to the existing shareholders. If they do not subscribe to the rights issue, the company might not raise the expected capital.
2. Dilution Risk: If existing shareholders do not fully subscribe to the rights issue, the company may sell the remaining shares to external investors, which could result in a dilution of ownership for the current shareholders.

For Shareholders:

1. Ownership Dilution: Shareholders who choose not to participate in the rights issue might experience a reduction in their ownership percentage within the company.
2. Financial Obligation: Participating in the rights issue requires shareholders to invest additional money, which may not always be manageable for everyone.
3. Market Sentiment: A rights issue can indicate that the company is facing financial challenges, potentially leading to a drop in its stock price.

 

How Does a Rights Issue Work?

Let’s understand through an example:

Suppose XYZ Ltd company’s share price is Rs.200 per share. Company launches 1:4 rights issue at Rs 150 per share. This means for every 4 shares a shareholder owns, they have the right to buy 1 additional share at Rs150.

In the case, shareholder participate in rights issue:

If Shareholder Owns 100 Shares, they are eligible to buy = 100÷4=25 share at the cost Rs 3750 [ Rs 150 per share]. Hence the market price is Rs 5000 [Rs 200 per share]. Thus, existing shareholder get benefits of Rs 1250, and they now own 125 shares (100 existing + 25 new).

If shareholder does not participate:

If a shareholder decides not to participate in the rights issue, he/she will still hold his/her original 100 shares, but since the total number of shares in the company increases, his/her ownership percentage in the company decreases. This is known as ownership dilution.

 

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Key Terms in Rights Issue:

1. Record Date: The date on which the company determines eligible shareholders who can participate in the rights issue.
2. Subscription Period: The duration within which shareholders must decide to exercise or sell their rights.
3. Renounceable Rights: Rights that can be sold to other investors if the shareholder chooses not to participate.
4. Non-Renounceable Rights: Rights that cannot be sold or transferred and must be either exercised or ignored.
5. Dilution: Reduction in ownership percentage for shareholders who do not participate in the rights issue.

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Conclusion:

A rights issue is a efficient way for companies to raise funds while giving first opportunity to the existing shareholders to maintain their stake. However, proper research and analysis are essential for the shareholders before participating in it. They need to evaluate the company's financial health, the purpose of the issue, and their ability to invest. 

Dr. Swati Gupta

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