The IPO Markets - Part 1

 The IPO Markets - Part 1

4.1 - Overview

Why do companies go public?

We will learn new financial concepts during the course of this chapter.

4.2 - Origin of a Business

why companies go public,

To understand this concept 

better, we will build a tangible story around it. Let us split this story into several scenes just so 

that we get a clear understanding of how the business and the funding environment evolves

SCENE 1 – THE ANGELS

Let us imagine a budding entrepreneur with a brilliant business idea – to manufacture highly fashionable, organic cotton t-shirts. The designs are unique, has attractive price points and the best quality cotton is used to make these t-shirts. He is confident that the business will be successful, and is all enthusiastic to launch the idea into a business

Let us assume that he pools in his own money and also convinces two of his good friends to invest in his business. Because these two friends are investing at the pre revenue stage and taking a blind bet on the entrepreneur they would be called the Angel investors. Please note, the money from the angels is not a loan, it is actually an investment made by them.

 

SCENE 2 – THE VENTURE CAPITALIST

His hard work pays off and the business starts to pick up.

The promoter is now more knowledgeable about his own business and of course more confident.

the promoter now wants to expand his business by adding 1 more manufacturing unit and few additional retail stores in the city. He chalks out the plan and figures out that the fresh investment needed for his business expansion is INR 7 Crs.

Let us assume he meets one such professional investor who agrees to 

give him 7 Crs for a 14% stake in his company.

The investor who typically invests in such early stage of business is called a Venture Capitalist (VC) and the money that the business gets at this stage is called Series A funding.

 

The VC is valuing the entire business at INR 50 Crs by valuing his 14% stake in the company at INR 7Crs.

SCENE 3 – THE BANKER

The company decides to have a retail presence in at least 3 more cities.

Whenever a company plans such expenditure to improve the overall business, the expenditure is called ‘Capital Expenditure’ or simply ‘CAPEX’.

The management estimates 40Crs towards their Capex requirements.

There are few options with the company to raise the required funds for their Capex…

1.The company has made some profits over the last few years; a part of the Capex requirement 

can be funded through the profits. This is also called funding through internal accruals

2.The company can approach another VC and raise another round of VC funding by allotting 

shares from the authorized capital – this is called Series B funding

3.The company can approach a bank and seek a loan. The bank would be happy to tender this 

loan as the company has been doing fairly well. The loan is also called ‘Debt’

The company decides to exercise all the three options at its disposal to raise the funds for Capex. 

It ploughs 15Crs from internal accruals, plans a series B - divests 5% equity for a consideration of 

10Crs from another VC and raise 15Crs debt from the banker.

Note, with 10Crs coming in for 5%, the valuation of the company now stands at 200 Crs. Of 

course, this may seem a bit exaggerated, but then the whole purpose of this story is drive across 

the concept!

 

Note, the company still has 31% of shares not allotted to shareholders which are now being valued at 62 Crs.

SCENE 4 – THE PRIVATE EQUITY

The company decides to raise the bar and branch out across the country. They also decide to diversify the company by manufacturing and retailing fashion accessories, designer cosmetics and perfumes.

The capex requirement for the new ambition is now pegged at 60 Crs. The company does not 

want to raise money through debt because of the interest rate burden, also called the finance 

charges which would eat away the profits the company generates.

They decide to allot shares from the authorized capital for a Series C funding. They cannot approach a typical VC because VC funding is usually small and runs into few crores. This is when a Private Equity (PE) investor comes into the picture.

They invest large amounts of money with the objective of not only providing the capital for constructive use but also place their own people on the board of the investee company to ensure the company steers in the required direction.

Assuming they pick up 15% stake for a consideration of 60Crs, they are now valuing the company at 400Crs. 

 

Please note, the company has retained back 16% stake which has not been allotted to any shareholder. This portion is value at 64 crs.

they do not invest in the early stage of a business instead they prefer to invest in companies that already has a revenue stream, and is in operation for a few years.

SCENE 5 – THE IPO

The promoter now aspires to go international! 

This time around the Capex requirement is huge and the management estimates this at 200 Crs. 

The company has few options to fund the Capex requirement.

1. Fund Capex from internal accruals

2.Raise Series D from another PE fund

3.Raise debt from bankers

4. Float a bond (this is another form of raising debt)

5. File for an Initial Public Offer (IPO) by allotting shares from authorized capital

6.A combination of all the above

When a company files for an IPO, they have to offer theirshares to the general public. The general public will subscribe to the shares (i.e if they want to) by paying a certain price. Now, because the company is offering the shares for the first time to the public, it is called the “Initial Public Offer’.

Key takeaways from this chapter

1.Before understanding why companies go public, it is important to understand the origin of 

business

2.The people who invest in your business in the pre-revenue stage are called Angel Investors

3.Angel investors take maximum risk. They take in as much risk as the promoter

4.The money that angels give to start the business is called the seed fund

5.Angel’s invest relatively a small amount of capital

6. Valuation of a company simply signifies how much the company is valued at. When one 

values the company they consider the company’s assets and liabilities

7.A face value is simply a denominator to indicate how much one share is originally worth

8.Authorized shares of the company is the total number of shares that are available with the 

company

9. The shares distributed from the authorized shares are called the issued shares. Issued shares 

are always a subset of authorized shares.

10.The shareholding pattern of a company tells us who owns how much stake in the company

11.Venture Capitalists invest at an early stage in business; they do not take as much risk as 

Angel investors. The quantum of investments by a VC is usually somewhere in between an 

angel and private equity investment

12.The money the company spends on business expansion is called capital expenditure or 

capex

13.Series A, B, andC etc are all funding that the company seeks as they start evolving. Usually 

higher the series, higher is the investment required.

14.Beyond a certain size, VCs cannot invest, and hence the company seeking investments will 

have to approach Private Equity firms

15.PE firms invest large sums of money and they usually invest at a slightly more mature stage 

of the business

16.In terms of risk, PE’s have a lower risk appetite as compared to VC or angels

17.Typical PE investors would like to deploy their own people on the board of the investee 

company to ensure business moves in the right direction

18.The valuation of the company increases as and when the business , revenues and 

profitability increases

19.An IPO is a process by means of which a company can raise fund. The funds raised can be for 

any valid reason – for CAPEX, restructuring debt, rewarding shareholders etc