The IPO Markets

Overview The initial three chapters has set the background on some of the basic market concepts that you need to know. At this stage it becomes imperative to address a very basic question – Why do companies go public? A good understanding of this topic lays down a sound foundation for all future topics. We will learn new financial concepts during the course of this chapter. Origin of a Business Before we jump ahead to seek an answer as to why companies go public, let us spend some time figuring out a more basic concept - the origins of a typical business. 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. 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. As a typical entrepreneur he is likely to be hit by the typical problem – where would he get the money to fund the idea? Assuming the entrepreneur has no business background he will not attract any serious investor at the initial stage. Chances are, he would approach his family and friends to pitch the idea and raise some money. He could approach the bank for a loan as well but this would not be the best option. 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. So let us imagine that the promoter along with the angels raise INR 5 Crore in capital. This initial money that he gets to kick start his business is called ‘The Seed Fund’. It is important to note that the seed fund will not sit in the entrepreneur’s (also called the promoter) personal bank account but instead sits in the company’s bank account. Once the seed capital hits the company’s bank account, the money will be referred to as the initial share capital of the company. In return of the initial seed investment, the original three (promoter plus 2 angels) will be issued share certificates of the company which entitles them an ownership in the company. The only asset that the company has at this stage is cash of INR 5 Crs, hence the value of the company is also INR 5 Crs. This is called the company’s valuation. Issuing shares is quite simple, the company assumes that each share is worth Rs.10 and because there is Rs.5 crore as share capital, there has to be 50 lakh shares with each share worth Rs.10. Inthis context, Rs.10 is called the ‘Face value’ (FV) of the share. The face value could be any number. If the FV is Rs.5, then the number of shares would be 1 crore, so on and so forth. The total of 50 lakh shares is called the Authorized shares of the company. These shares have to be allotted amongst the promoter and two angels plus the company has to retain some amount of shares with itself to be issued in the future. So let us assume the promoter retains 40% of the shares and the two angels get 5% each and the company retains 50% of the shares. Since the promoter and two angels own 50% of the shares, this allotted portion is called Issued shares. The share holding pattern of this company would look something like this.. Please note the balance 50% of the shares totaling 2,500,000 equity shares are retained by the company. These shares are authorized but not allotted. Now backed by a good company structure and a healthy seed fund the promoter kick starts his business operations. He wants to move cautiously, hence he decides to open just one small manufacturing unit and one store to retail his product. SCENE 2 – THE VENTURE CAPITALIST His hard work pays off and the business starts to pick up. At the end of the first two years of operations, the company starts to break even. The promoter is now no longer a rookie business owner, instead he is more knowledgeable about his own business and of course more confident. Backed by his confidence, 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. He is now in a better situation when compared to where he was two years ago. The big difference is the fact that his business is generating revenues. Healthy inflow of revenue validates the business and its offerings. He is now in a situation where he can access reasonably savvy investors for investing in his business. 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. After the company agrees to allot 14% to the VC from the authorized capital the shareholding pattern looks like this: Note, the balance 36% of shares is still retained within the company and has not been issued. Now, with the VC’s money coming into the business, a very interesting development has taken place. The VC is valuing the entire business at INR 50 Crs by valuing his 14% stake in the company at INR 7Crs. With the initial valuation of 5Crs, there is a 10 fold increase in the company’s valuation. This is what a good business plan, validated by a healthy revenue stream can do to businesses. It works as a perfect recipe for wealth creation. With the valuations going up, the investments made by the initial investors will have an impact. The following table summarizes the same… Going forward with our story, the promoter now has the additional capital he requires for the business. The company gets an additional manufacturing unit and few more retail outlets in the city as planned. Things are going great; popularity of the product grows, translating into higher revenues, management team gets more professional thereby increasing the operational efficiency and all this translates to better profits.