How IPOs Work in India: Reading the Prospectus Before You Apply

An initial public offering, or IPO, is the first time a company sells its shares to the public. The company, its owners or both raise money, and the shares then trade on the stock exchanges. Applying is easy, which is part of the danger. Deciding whether the price is sensible is the hard part.

The steps of an IPO

• The draft. The company files a Draft Red Herring Prospectus (DRHP) with SEBI. This is a detailed document about the business, finances, risks and the purpose of the issue.
• The final document. After SEBI's observations, the company files the Red Herring Prospectus (RHP) and announces the price band and opening date.
• Bidding. The issue stays open for a few days. You apply through your broker or bank using UPI or ASBA, which blocks the money in your account instead of debiting it.
• Allotment and listing. The basis of allotment is finalised, unused blocked money is released, and shares reach your demat account. The rules require listing within three working days of the issue closing.

Who gets what

Shares are reserved for different groups. In a standard issue, qualified institutional buyers can receive up to half, non-institutional investors at least 15 percent, and retail investors at least 35 percent, with the exact split set out in the prospectus. A retail investor is someone applying for up to Rs 2 lakh. Only one application per PAN is allowed for each issue, and duplicates are rejected.

Anchor investors, who are large institutions, are allotted shares a day before the issue opens. A portion of their shares is locked in for 30 days and the rest for 90 days after allotment. The end of a lock-in can bring a lot of shares to the market, which some investors watch.

What to read in the prospectus

You do not need to read every page. Start with these.

• Objects of the issue. Where will the money go: growth, repaying debt, or paying existing owners?
• Fresh issue versus offer for sale. A fresh issue puts money into the company. An offer for sale puts money into the pockets of selling shareholders. A mix is common, but an issue that is mostly an exit by existing owners deserves a closer look.
• Risk factors. Companies must list them, and the order often shows what worries management most.
• Financials. Look at revenue, profit and cash flow over several years, not just the latest one.
• Promoter holding. How much will the promoters own before and after the issue?
• Valuation. Compare the price with listed companies in the same business, using the same measures.

A simple example shows what comparing means. Say a company earns Rs 100 crore a year and the issue values it at Rs 3,000 crore, which is 30 times earnings. If listed companies in the same line of business trade near 20 times, the issue is priced at a premium. That may be justified by faster growth or better returns, but you should be able to say why before you apply.

What a grey market premium is not

You may hear about a grey market premium before listing. It is an unofficial, unregulated indication of what some traders expect, and it can swing quickly or be wrong. It is not information about the company. Treat it as noise.

Allotment is not the goal

Many applicants judge an IPO by whether they got shares. A better judgement is whether they wanted to own the business at that price. Listing-day gains have varied widely across issues, and a gain on one says little about the next. Our notes on chasing a move and confirmation bias explain why a crowded IPO can feel safer than it is.

Questions to ask before applying

• Do I understand how this company makes money?
• Is the price reasonable compared with similar companies?
• Why are the existing owners selling, if they are?
• Would I be comfortable holding this if it fell 30 percent after listing?

Common questions

Are SME IPOs the same as main board IPOs?

No. SME issues are for smaller companies, often have larger minimum application sizes and thinner trading, and carry higher risk. Read their documents with extra care.

Can I sell on listing day?

Yes, shares allotted to you can be sold once they are listed. Whether to do so is your own decision and carries market risk like any other trade.

Sources: IPO structure, reservation and timing as described in Anand Rathi's guide to SEBI's IPO rules. Rules change, so check SEBI's current regulations and the prospectus of any issue you consider.