How does IPO allotment work?

By Abhishek Katti

It is a well known fact that any firm requires capital for its regular functioning and repayment of debt to banks. Here is when Initial Public Offering ( IPO) comes into the picture. Before moving on to the process of IPO allotment, which sounds a little complex, it would be in the best interest of the readers to know what actually is an IPO, how do companies register for one and how does IPO allotment work?

What Is An IPO?

To understand how does IPO allotment work, we need to first understand what is an IPO. Every firm starts with a minimal level of funding that usually originates from family, friends and their own personal savings. In fact, many entrepreneurs successfully fund their ideas after convincing private banks and investment firms. 

A startup usually grows in three stages based on the source of funding. The first stage begins with the funds coming in from immediate family members and friends. The second stage occurs when the company gives a good amount of profits and hence attracts an angle investor, who helps the company grow and expand its footprint in the market. 

The next stage takes place when the company grows to such an extent that it starts to attract venture capitalist firms to invest in its company and finally comes the IPO when a company opens up its doors to the public and hence converts it self fromprivate firm to a public firm. This is the stage when we often hear the phrase “A company chose to become public.”

An initial public offering is the first sale of a stock when a company gets listed on the stock market. In India we have the National Stock Exchange and the Bombay Stock Exchange. A company is defined as a private one when it is owned by a small number of investors.  A public company, on the other hand, allows itself to be owned by a large number of investors which consists of both Institutional investors and retail investors.

Retail Vs Institutional Investors

It is a whole different process of how a company gets its name on the stock market so that it would be eligible to sell its stocks to retail investors.

However, it is important to be aware of the difference between retail investors and institutional investors. Institutional investors involve pension funds, insurance companies, hedge and mutual funds, investment banks and NBFCs. Retail investors are  individual investors who do not invest on anyone else’s behalf. In other words, they manage their own money and choose to invest through brokers, banks or real estate agents.

How Does IPO allotment Work For Retail Investors?

Moving on to the allotment process for retail investors, there are certain rules and regulations imposed by the Securities and Exchange Board of India ( SEBI).

It would be easier to grasp the concept of allotment if we drew our attention towards some of the basic terms used in the arena of IPOs. In the year 2019, many IPOs including IRCTC, Ujjivan bank and CSB bank got “subscribed” multiple times and hence it left many retail investors “disappointed” for not being able to get share allotment.

The term “subscribed” means the number of retail investors willing to buy shares. In case of CSB Bank, the minimum bid lot was 75 equity shares and the quota reserved for retail investors was 18% which equals 21,00,906 shares.  The number of shares subscribed for were 9,35,51,025 which was 44.5 times. In an ideal scenario, the number of share holders should account to approximately 28,000 . This is the number, you can arrive at once you divide 21,00906 by 75.

If the Investment & the Investor is :Retail Institutional InvestorNon institutional InvestorQualified Institutional investor (Anchor Investor)QIIs
< 2 Lakh RupeesQualified
>2 Lakh RupeesQualified (HNI, Corporates, etc.)
Min = Rs 10 cr. Max = 60% QIBQualified(1/3rd-Domestic mutual funds2/3-Other Anchor Investors
Remaining 40% after allotment to anchor investorsQualified

When a company decides to become public, there are two kinds of offerings  termed as initial public offerings and further public offerings (FPO). A further public offering is issuing additional shares by a company to investors. In a FPO, the company is already listed on the stock exchange.  

Book Building Issue Vs Fixed Price Issue

There are two methods by which an IPO is issued namely “Fixed Price Issue” and “Book Building Issue”. It is always recommended by SEBI that The Book building issue method should be implemented because of the fact, that it has lower risks as compared to the Fixed Price Issue.

 The sole reason for a lower risk is because the Book Building Issue includes not just quantitative pricing methods but also the qualitative methods such as public demand.

Source : BSE

Common Terminologies To Understand How IPO Allotment Works

To understand how IPO allotment works, we need to first know the terms associated with it. Getting back to the common terms used, let us examine an example of an imaginary company, say Company X. Following is the chart which has been elaborated in the following paragraphs.

TERMS                                                              VALUE
Number of Shares to be issued 10 Crore shares
Price band (Book Building Issue) Floor Price ( fp) – Rs 225
Cap Price ( cp) – Rs 250
*CP = FP + 20% ( FP)
Lot size50 shares
Minimum Investment Rs 11,250 – Rs 12,500
Tick SizeRs 5

The number of shares to be issued is always less than the total number of shares since a percentage of shares are reserved for other types of investors. 

The price band is the range of price per share and according to SEBI norms, only retail investors can bid at the cap price which is the maximum price of a share. 

Thefloor price of a share, on the other hand, is the minimum price per share. Any retail investor has to invest a minimum amount which is decided based on lot size

In the above example, the lot size is set to be 50. This means that the investors ought to buy minimum one lot and maximum depending on the percentage of reservations for retail investors.

 Finally comes the tick size which happens to be the step size with which the price can be bid within the price band. As a result, the following table would generate if the tick size is set to Rupees 5.

Bid Price (Rupees) per share                              Demand of shares ( Crores)
250 (Cap Price)4
225 ( Floor Price) 2

When a company has a target of selling off, lets say, 10 Crore shares, then based on the above chart, the investment  bank would analyze the demand at deferent rates of shares. Based on that, a “cut off price” isdecided which is the price at which all the shares can be sold.

Now, what happens when we have excessive, moderate or at most very less demand? In this case, how does IPO allotment work?

According to the guidelines dictated by SEBI, if the demand for shares offered through IPOs is less than 90% then the entire IPO is scrapped off resulting in the company’s removal from the respective stock exchange and all funds are returned back to the investors. 

Secondly,  if there is a moderate demand,  it is mandatory that every investor is allotted at least one lot and the rest of the shares are distributed proportionately. On the other hand, if the demand is excessive such as the case of IRCTC, there is a computerized lucky draw held for the allotment of shares specifically to retail investors. 

In the case of NIIs and QIBs, there is a proportionate allotment of shares.

On a concluding note, the entire circus of investments in IPOs seems a little tedious but it is always worthwhile to explore something that has the potential of multiplying your savings after tax, thereby allowing  investors to improve their trajectory and future goals.

This article is authored by Abhishek Katti. He is a graduate of technology from NIT Allahabad. He writes about topics such as economy, financial planning, investments and wealth management.

Read about another interesting topic – 5 Things To Know While Applying For An IPO.

Post Author: Fintox_India