IPO investing: Is it the right strategy for you?

Investing in Initial Public Offerings (IPOs) offers a unique opportunity to get in early on companies before they become widely known. An IPO marks the first time a private company sells its shares to the public, making it a much-anticipated event in the financial markets.

For many investors, the biggest lure of IPOs is the potential for listing gains - sharp price increases on the day of listing driven by high demand. However, just as prices can surge, they can also drop quickly once the initial excitement fades.

That said, every great company starts somewhere. While it's difficult to identify future stars at the IPO stage, the potential rewards from backing the right ones early can be significant.

In this article, we'll take you through everything you need to know about IPO investing - from analysing a company to understanding how to invest in one.

What is an IPO?

An Initial Public Offering (IPO) is the process by which a private company offers its shares to the public for the first time. It marks the transition from a privately held company to a publicly traded one. IPOs are significant events in the financial markets because they allow companies to raise capital by selling equity to investors.

There are two primary markets where securities are traded:

• Primary market (IPO): The first market where new securities (like stocks) are offered.
  
• Secondary market (Stock investing): Where previously issued stocks are bought and sold among investors.

During an IPO, the company sells a portion of its ownership to the public. This capital infusion can be used for various purposes, including expansion, research and development, or paying off existing debt. Retail investors often look at IPOs as an opportunity to get in early on a company that may grow significantly over time.

Why do companies launch IPOs?

Companies go public through an IPO for several reasons, most of which are focused on growth and sustainability.

Raising capital for growth

The primary reason companies launch IPOs is to raise capital. This money is often used for various purposes such as expansion, acquisitions, or research and development. Going public allows companies to access a large pool of funds to fuel their business plans.

Enhancing brand visibility and credibility

Being listed on a stock exchange raises a company's profile and boosts its credibility. This visibility can attract customers, potential business partners, and top talent.

Providing exit for early investors and promoters

For early-stage investors like venture capitalists and company promoters, an IPO offers an exit strategy. They can sell their shares and realize the gains from their initial investment.

Debt reduction and balance sheet strengthening

An IPO can help reduce a company's debt burden and strengthen its balance sheet by raising equity capital. This can improve the company's financial stability and make it more attractive to future investors.

Suggested read: Warning signs in tiny IPOs

How does an IPO work?

The process of launching an IPO involves several key steps, ensuring that both the company and investors are properly prepared for the event. Here's a breakdown of how an IPO works:

Step 1: The company decides to go public

The company must first decide that going public is the right move. This decision usually stems from the need to raise funds for expansion or to capitalize on favourable market conditions.

Step 2: The appointment of investment bankers and underwriters

Once the decision is made, the company hires investment bankers and underwriters to manage the IPO process. These professionals help determine the initial offering price and oversee the regulatory filing process.

Step 3: Filing of Draft Red Herring Prospectus (DRHP) with SEBI

The company must file a DRHP with the Securities and Exchange Board of India (SEBI) for approval. The DRHP includes detailed information about the company's business, financial health, and the terms of the IPO.

Step 4: IPO pricing and valuation

The company, with the help of its underwriters, determines whether the IPO will be priced through a Fixed Price model (where the price is predetermined) or a Book Building process (where the price is determined based on investor demand).

Step 5: The IPO subscription process

Investors can apply for IPO shares through the subscription process. Different categories of investors, including retail investors, institutional investors, and high-net-worth individuals (HNIs), participate in the subscription.

Step 6: Allotment of shares and listing on the stock exchange

Once the shares are allotted, they are listed on stock exchanges like the Bombay Stock Exchange (BSE) or the National Stock Exchange (NSE). Investors can then start trading the shares in the secondary market.

Suggested read: Understanding the IPO process

What types of IPOs are there?

There are two main types of IPOs, each with different pricing mechanisms:

Fixed price IPO

In a Fixed Price IPO, the price at which the shares will be sold is set in advance and disclosed to investors. This provides certainty for investors but may not always reflect market demand accurately.

Book building IPO

In a Book building IPO, the price of the shares is determined by the demand from investors. The company and its underwriters gather bids from institutional investors, which helps set a final price based on investor interest.

How to invest in an IPO?

Investing in an IPO is a straightforward process, but it requires some preparation. Here's how you can get started:

Step 1: Open a Demat and trading account

You need to open a Demat account with the Central Depository Services (India) Ltd (CDSL) or the National Securities Depository Ltd (NSDL), which can be done either directly or through a participant like a broker or a bank.

Step 2: Choose an IPO and read the prospectus

Once your account is set up, you can choose an IPO you want to invest in. It's important to read the company's prospectus, which provides valuable information on the company's business model, financial performance, and risks involved. It is available online on exchange websites (BSE and NSE) or on various booking websites.

Step 3: Apply for the IPO through ASBA (Application Supported by Blocked Amount)

An IPO application is made through the ASBA (applications supported by blocked amount) format, where the amount needed for the IPO is blocked in your bank account but not debited.

Step 4: Wait for IPO allotment and listing

To apply, you need to set a price range and total amount and enter your bank and Demat account details. After applying, you will have to wait for the allotment process. If you're successful, the shares will be credited to your Demat account and will be listed on the stock exchange for trading.

Suggested read: How to invest in an initial public offer (IPO)

What are the advantages of investing in IPOs?

IPO investing draws in a number of investors due to the potential of listing gains. Listing gains refer to the sharp surge in the price of a company right on the date it lists. This can be understood through simple demand and supply dynamics.

If a company is highly sought after by investors, many will fight for a place as shareholders. However, there's a limited number of shares issued at an IPO. Therefore, due to high demand amid limited supply, the share price of the company upon listing skyrockets.

This quick appreciation can make a person some good money in a short time. That said, many sell their shares quickly after the initial excitement fades. And this can result in a company's share price falling dramatically. This drop is even more severe when the company's fundamentals are weak.

Suggested read: From IPO to un-IPO, a strange story

What are the risks and challenges of IPO investing?

While IPO investing can be lucrative, it is not without risks:

• High demand, limited allotment: Many IPOs are oversubscribed, meaning not all investors will receive an allotment.
  
• IPO performance uncertainty: Not all IPOs perform well after listing. The stock might drop, and you could incur losses.
  
• Lock-in period for anchor investors: Anchor investors may sell their shares after the lock-in period, causing price volatility.
  
• Market sentiment can impact pricing: The overall market sentiment can affect the IPO's pricing and its subsequent performance.

How to evaluate an IPO before investing

Before jumping into an IPO, it's crucial to evaluate it thoroughly. Here are some factors to consider:

• Company's financial performance: Assess the company's financial health and growth prospects.
  
• Industry trends: Understand the industry the company operates in and its competitive landscape.
  
• Use of funds: How will the IPO funds be used? Will they fuel growth or reduce debt?
  
• Valuation and pricing: Compare the company's valuation to its peers in the industry.
  
• Promoter and management credibility: Look into the credibility of the company's promoters and management.
  
• Subscription status: Gauge the demand for the IPO by looking at how much it's been subscribed to.

IPO vs buying stocks from the secondary market: Which is better?

Is IPO investing better than buying stocks from the secondary market?

The answer depends on your investment goals:

• IPO investing: Great for those who are looking to be an early entrant and are looking to make substantial listing gains.
  
• Secondary market investing: Ideal for those who prefer stability and a company's historical performance data.

Your choice should align with your risk tolerance and financial objectives.

Is IPO investing right for you?

IPO investing can be a rewarding strategy, but it comes with risks. It offers early entry into high-growth companies, but market timing and other factors can influence its success.

Also, remember that IPOs of companies with sound fundamentals often get oversubscribed. Therefore, getting an allotment in a worthwhile IPO is much like a lottery. The odds of receiving shares in such a company will be slim.

Also read: Investors' Hangout: IPOs - Why should you not invest in them?

This article was originally published on May 05, 2025.