Before we answer the question of why companies come up with IPOs, we need to know and understand some basic concepts like how any company gets started. Let us understand this through a story, and divide this story into some different scenes so that we can understand that how the system of business and funding i.e. capital raising works, how it is formed and grows?
Scene 1.
Let’s say there is a businessman or entrepreneur who has a great business idea. That business idea is to make and sell fashionable T-shirts made of organic cotton. These t-shirts will have unique designs, attractive prices for the customers, and use the best quality cotton in their production. The entrepreneur is sure that this business will be successful and he is also very excited to turn this idea into a business.
As with other entrepreneurs, before doing anything he will have one question – where will the money for this business come from. Let’s say he doesn’t 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 in the bank, but it will not be a good option at this stage.
Then let’s assume that he invests his deposits and simultaneously convinces two of his friends to invest money in the business. These two friends are investing money in the business even before it starts earning and are kind of betting on the entrepreneur. In such a situation, these two friends will be called Angel Investors. Here you should note that the money invested by angel investors is not a loan but is invested in the business.
Now suppose the promoter (who has the business idea) and the angel investors together added Rs 5 crore. This capital will be called the “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 exchange for this seed investment, all three shareholders (promoter and 2 angel investors) are issued share certificates of the company, which show that all three are owners of the company or have ownership.
At present, the company has only Rs 5 crore, this is the only asset of the company. Hence the value of the company is also Rs 5 crore. This is called the valuation of the company.
It is very easy to issue shares. 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 price of this share is Rs 10, it is called the face value of the share. The face value does not necessarily have to be only Rs 10, it can be more or less. If the face value is Rs 5, then the number of shares will become 1 crore.
The above 50 lakh shares were issued, it is called Authorized Shares of the company. Some of this part is divided among the three i.e. promoters and 2 angel investors, while keeping in mind the future, some shares are kept with the company.
Now let’s say the promoter gets 40 percent of the shares, and both the angel investors get 5-5 percent. 50% of the shares were held with the company. The shares which are received by the promoters and angel investors are called Issued Shares.
The shareholding pattern of the company will be something like this…
| No. | Name of the Share Holder | No. of Shares | Holding (%) |
|---|---|---|---|
| 1 | Promoter | 2,000,000 | 40 |
| 2 | Angel 1 | 250,000 | 5 |
| 3 | Angel 2 | 250,000 | 5 |
| Total | 2,500,000 | 50% |
Remember that the remaining 50% of the shares are with the company. These are authorized shares, but not allotted to anyone.
Now the promoter has the company, and a good seed fund too. Promoter starts the business, but he proceeds with a little caution and opens a small manufacturing unit and only one retail store to manufacture and sell his product.
Scene 2- The Venture Capitalist
The promoter’s hard work pays off and by the end of the second year, the expenses and income of the company become equal. When the expenses and income of the company are equal, it is said that the company is at the breaking even point. The promoter also now has the experience of running the company and more confidence than ever before. Now the promoter wants to expand the business a bit. He wants 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 take the capital of Rs 7 crore.
The condition of the promoter is quite different now than before. Earnings are increasing continuously in the business. Hence the promoter can go to the investors who invest money in the new business. Let’s say he talked to one such investor, who agreed to pay him Rs 7 crore in return for a 14% stake in the company.
Such investors who invest money in the initial years or phases 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 allows 14% of the authorized capital to the VC, the shareholding pattern will now be like this…
| No. | Name of the Share Holder | No. of Shares | Holding (%) |
|---|---|---|---|
| 1 | Promotor | 2,000,000 | 40 |
| 2 | Angel 1 | 250,000 | 5 |
| 3 | Angel 2 | 250,000 | 5 |
| 4 | Venture Capitalist | 700,000 | 14 |
| Total | 3,200,000 | 64 |
Remember that the remaining 36% of the shares are still with the company and have not been issued.
Now a new thing is happening after VC money comes into the business. The VC has given a valuation of 50 crores to the entire company by paying 7 crores for its 14% stake or shares. This is 10 times more than the initial valuation of 5 crores. This is how the business gets the benefit of a good business plan and good income. This is how the business gets bigger. With the increase in the valuation of the company, there is also an impact on the investment of the initial investors, which you can understand from the table below.
| No. | Name of the Share Holder | Initial Share Holding | Initial Valuation | After 2 Years Share Holding | After 2 Years Valuation | Wealth Creation |
|---|---|---|---|---|---|---|
| 1 | Promoter | 40% | 2 cr | 40% | 20 cr | 10 times |
| 2 | Angel 1 | 5% | 2.5 cr | 5% | 25 cr | 10 times |
| 3 | Angel 2 | 5% | 2.5 cr | 5% | 25 cr | 10 times |
| 4 | VC | 0% | NA | 14% | 07 cr | NA |
| Total | 50% | 2.5 cr |
64% | 32 cr |
Proceed with the story. The promoter now has the additional capital that he needed to grow the business. The company got a new manufacturing unit and a few retail outlets. Everything is going great. The popularity of the product is increasing due to which more income is being generated. The management team is getting better, which is improving the performance and increasing the profits of the company.
Scene 3: The Banker
3 more years passed. The company is touching new heights 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 also have to increase production capacity and recruit new people. Such expenses, which the company incurs to grow and improve the business, are called capital expenditure or CAPEX.
The management thinks that Rs 40 crore will be required for this work. So the question arises that how will the company fulfill this need?
There are few options before the company to add to this capital
The profit earned by the company in the last few years can be used to meet the CAPEX requirement. This way is called internal accruals or raising money from internal sources.
The company can go to another VC and ask for VC funding again. For this, he will have to give shares to the VC. This is called Series B funding.
The company can ask for a loan by going to a bank. Since the company is doing good business, it will not be difficult for the company to get a loan.
The company followed the above three routes – 15 crores from internal sources, 10 crores by giving 5% equity in Series B, and 15 crore loan from a bank.
Note that by getting 10 crores in lieu of 5% equity, the valuation of the company is seen as 200 crores. It may be a bit much, but for now, we just take it for the sake of the story.
Now the shareholding and valuation of the company will look like this…
| No. | Name of the shareholder | No. of shares | Holding(%) | Valuation (in Crores) |
|---|---|---|---|---|
| 1 | Promoter | 2,000,000 | 40 | 80 |
| 2 | Angel 1 | 250,000 | 5 | 10 |
| 3 | Angel 2 | 250,000 | 5 | 10 |
| 4 | VC Series A | 700,000 | 14 | 28 |
| 5 | VC Series B | 250,000 | 5 | 10 |
You will see that the company has not allotted 31% of the shares to any shareholder yet. The value of these shares is currently Rs 62 crores. This is how company capital grows, especially when an entrepreneur has a good business idea and a good management team.
You will see such examples in Infosys, Page Industries, Eicher Motors, and internationally in Google, Facebook, Twitter, and WhatsApp, etc.
Scene 4- The Private Equity- PE
Few years pass and the company reaches new heights of success. With success, this 8-year-old 200 crore company gets filled with more enthusiasm. The company now wants to spread its business across the country. The company is now looking to build its own factory and sell fashion accessories, designer cosmetics, and perfumes.
For this new work, the company sees a need for CAPEX of 60 crores. The company does not want to take loans, as paying interest will reduce its profits.
The company wants to get Series C funding by giving some more shares to the VC. But it cannot go to any normal or common VC because VC funding is available only for few crores. Hence, now the company will have to approach a private equity investor.
PE investors are very knowledgeable. they have vast experience. They invest large sums of money and also put their people on the board of the company so that the company moves in a certain direction. Suppose an investor takes a 15% share and pays Rs 60 crore for it. In this way, the valuation of the company will now reach 400 crores. Now let’s take a look at the company’s shareholding and valuation…
| No. | Name of the shareholder | No. of shares | Holding (%) | Valuation (in crores) |
|---|---|---|---|---|
| 1 | Promoter | 2,000,000 | 40 | 160 |
| 2 | Angel 1 | 250,000 | 5 | 20 |
| 3 | Angel 2 | 250,000 | 5 | 20 |
| 4 | VC A | 700,000 | 14 | 56 |
| 5 | VC B | 250,000 | 5 | 20 |
| 6 | PE Series C | 7,50,000 | 15 | 60 |
| Total | 4,200,000 | 84 | 336 |
Remember that the company has still kept the 16% share which has not been allotted to anyone. Its price is now 64 crores.
Usually, when a PE invests, it pays for a large CAPEX requirement. PE never invests money in the initial phase of business rather he invests money in companies which are working for few years and earning income. Taking money from PE and putting that money in CAPEX is a long time job and it takes few years.
Scene 5- The IPO
The business of the company has grown tremendously after 5 years of PE investment. 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 spread the business abroad 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 are the preferences of the people there. The company will have to hire new people and 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
- Internal Accruals – Internal Sources
- Series D funding from PE funds
- More loans from a bank
- Issuing bonds (another form of debt)
- issue of shares through ipo
- combination of all the above paths
Suppose the company decides to raise part of the CAPEX from internal sources and the rest from IPO. When the company brings 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
- Why did the company decide to launch an IPO and why does the company take this route?
- Why didn’t the company go for IPO earlier in Series A, B, and C?
- What will happen to the existing shareholders after the IPO?
- What does the general public look for before investing money in an IPO?
- How does this entire process of IPO proceed?
- Which financial intermediaries work in the IPO market?
- What happens when a company brings a public issue?
Important points of this chapter:
- Before understanding why a company comes into the stock market, it is more important to understand how companies are formed, where they start, and how.
- Those who invest in the business before the revenue or income comes, are called Angel Investors.
- Angel investors take the highest risk. It can be said that promoters and angel investors take equal risks.
- The capital that angel investors give to start a business is called a seed fund.
- Angel investors invest less money than others.
- The valuation of the company tells how much the company is being valued. The value of the company is arrived at by taking into account the assets and liabilities of the company.
- Face value shows the actual value of the share.
- All the shares held by the company are called Authorized Shares.
- The shares issued out of the authorized shares are called Issued Shares.
- The company’s shareholding pattern tells us who has a share in the company.
- Venture capitalists invest in the early stages of the company, so the risk taken by them is less than that of angel investors. The amount invested by a VC is usually somewhere between an angel and private equity investments.
- The money that the company makes to expand or expand the business is called capital expenditure or CAPEX.
- As the company grows, it needs funding in Series A, B, C, etc. Usually the higher the series, the larger the amount required
- VCs cannot invest in the company beyond a certain limit. In such a situation, the company has to approach the private equity firm.
- Private equity firms invest a large amount of capital and they usually invest after the initial phase of the business, when the business becomes a bit stable.
- The risk appetite of a private equity firm in terms of risk is less than that of VCs or angel investors.
- Private equity firms want to have their own people on the board of the company they invest in so that the business runs in the right direction.
- The valuation of a company increases with the increase in its business, income, and profits.
- The company can raise capital through the process of IPO. The company can use this capital for different purposes, such as CAPEX, restructuring of debt, etc.
Do check the IPO Part 2
Gaurav Heera is a well known name in the field of stock market analysis and education. His distinguished career, which spans more than ten years, has cemented his reputation as an expert with unparalleled knowledge and innovative strategies for navigating the intricate landscape of the financial markets.
