When the stock market is strong, as is the case now, you will find a lot of companies coming out with IPOs. I often get asked if it makes sense to invest in these IPOs. My answer to that is, “it depends”. First of all, let us explore what the IPO actually is.
In an IPO or Initial Public Offering, the promoters of the company sell some of the shares of the company to the public. Hence the term, “public offering”. When they do it for the first time, it becomes “Initial Public Offering”.
Let us take an example of a well-known company like Flipkart. The brand is known to most of us, either because we have used the e-commerce platform to buy something or through their numerous TV and print media advertisements. Flipkart was established by its founders Sachin Bansal and Binny Bansal. Then, venture capital investors invested in the company and picked up a stake in the company. This, however, was a private transaction. These privately held shares are not listed on the stock market and cannot be traded on an exchange. The buyer can still exit the investment by selling it to another private buyer, but, to put it mildly, the search cost of finding a potential buyer for one’s shares at a price acceptable to the seller can be very high.
Raising capital
What happens to the money invested by the venture capital investor? If new shares are issued, that money goes to that company and can be used for growing the company. On the other hand, if the promoter/founder sells their shares, then the money goes to the promoter or the founder and not to the company. It can also be a mixture, where a pool of shares is sold, some new and some from the existing shareholders (founders/early investors). The money from new share sales go to the company and the money from sale of existing shares go to the existing shareholders. If this is not clear, please re-read the previous sentences till you understand this.
Now, a company can raise capital for two reasons: (a) to give liquidity or exit to existing shareholders including but not limited to promoters; (b) to fund the growth opportunities. In an IPO, a company can be raising money from the public for either (a), (b) or a combination of (a) and (b).
What you need to consider when you want to invest
Now, think for a moment and try to answer where would you like to invest? Ideally, we would want to invest in a company that is raising money to pursue exciting growth opportunities. There is nothing exciting about giving exit to the promoters and other early investors. Usually, what we would find in an IPO is a mix of (a) and (b). It is understandable that the founders and private investors want an exit and that is a reasonable expectation from their side. But if the capital raised is predominantly going for exit to the existing investors, you need to be worried. As an interesting exercise, why don’t you find out what percentage of the fund raise of any one of the most recent IPOs is going to fund the growth opportunities of the company? Do not forget to email me your findings.
The writer is an alumnus of IIM Bangalore and co-founder, Money Wizards. chari.venkatesh@gmail.com
