Primary Market What It Is and How Companies Raise Funds

The financial markets are the lifeblood of any economy by providing a platform for businesses to raise capital and for investors to purchase securities. Understanding the dynamics of these markets is crucial for investors and analysts alike. Among the various segments of financial markets, the primary market holds a unique and significant position. 

This article explores the primary and secondary market, outlining what they are, how companies raise funds there, and the various mechanisms involved, with a focus on the Indian context.

Understanding the Primary Market

The primary market, also known as the new issue market, is where securities are created and sold for the first time. It is primarily concerned with the issuance of new stocks and bonds, allowing companies and governments to raise funds from investors. The key characteristic of the primary market is that the securities sold are issued directly by the issuer to the investor, with the proceeds going directly to the issuer.

In contrast, the secondary market is where existing securities are traded between investors. This trading does not provide funds to the issuers; instead, it facilitates liquidity and price discovery for the securities issued in the primary market.

How Companies Raise Funds in the Primary Market

There are several methods through which companies can raise funds in the primary market. These include:

1. Initial Public Offering (IPO): An IPO is when a company offers its shares to the public for the first time. This process transforms a private company into a public one. IPOs are often popular because they enable firms to raise substantial capital. For example, Zomato's IPO in July 2021 raised INR 9,375 crores.

2. Follow-on Public Offering (FPO): An FPO is when a company that is already publicly listed issues additional shares to raise more capital. This could be done to fund expansion, pay off debt, or for other strategic purposes.

3. Rights Issue: A rights issue gives existing shareholders the right to purchase additional shares at a discounted price before the new shares are offered to the public. It is a way for companies to raise equity capital while giving preference to existing investors.

4. Private Placement: This involves selling securities to a relatively small number of select investors, such as large banks, mutual funds, insurance companies, and pension funds. Private placements are more straightforward than public offerings and do not require the same level of regulatory compliance.

5. Preferential Allotment: This is similar to private placement but often reserved for a select set of investors such as promoters, friends, and associates of the entrepreneurs. It allows companies to raise quick capital without going through the lengthy process of public offerings.

Key Considerations and Calculations

Raising funds through the primary market involves several steps and considerations. Calculations related to the pricing of shares, valuation of the company, and understanding investor sentiment are crucial. Let’s take an example of an IPO to illustrate these aspects.

Case Study: ABC Ltd.'s IPO

Assume ABC Ltd. plans to go public and intends to raise INR 500 crores through an IPO. Here’s how the process works:

1. Valuation:

- The company hires investment bankers to determine its valuation.

- Based on revenue, profit, market conditions, and industry comparisons, ABC Ltd. is valued at INR 2,500 crores.

2. Shares Issued:

- If ABC Ltd.'s valuation is INR 2,500 crores and it plans to raise INR 500 crores, it will issue shares worth 20% of its post-issue value.

- To find the price per share, suppose ABC Ltd.'s pre-issue share count is 10 crores.

- Post-issue, the share count will be 12.5 crores (10 crores pre-issue + 2.5 crores new shares).

3. Pricing:

- Therefore, the price per share can be calculated as follows:

- \[\text{Price per share} = \frac{\text{Post-issue valuation}}{\text{Total number of shares}} = \frac{\text{INR 3,000 crores}}{12.5 \text{ crores}} = INR 240 \text{ per share}\]

- However, companies might choose to offer shares at a discount to ensure better subscription, say at INR 200 per share to raise INR 500 crores.

4. Regulatory Compliance:

- The company must get approvals from regulators like the Securities and Exchange Board of India (SEBI).

- A draft red herring prospectus (DRHP) is filed, containing detailed financial statements and disclosures.

5. Marketing:

- The IPO is marketed through roadshows and investor meetings to generate interest.

6.Subscription and Allotment:

- Investors apply for shares during the subscription period.

- Demand is analyzed, and shares are allotted accordingly.

Risks and Rewards

Investing in the primary market carries both risks and rewards. On the one hand, participating in an IPO can offer substantial returns if the company performs well. For example, investors in the IRCTC IPO saw their investments perform admirably post-listing.

On the other hand, there are risks associated with market volatility, company performance, and broader economic factors. Historical data shows that not all IPOs perform well post-listing, and some can lead to losses for investors.

Conclusion

The primary market is fundamental to the capital-raising process for companies and represents a crucial component of the broader financial markets. By understanding the mechanisms and processes involved, investors can make informed decisions about participating in IPOs and other primary market activities.

However, it is essential to weigh the pros and cons before making any investment decisions. The Indian stock market, like any other, comes with its share of risks, and investors should conduct thorough research and consult with financial advisors as needed.

 Disclaimer

This article is for informational purposes only and does not constitute financial advice. Investors must carefully gauge all the pros and cons of trading in the Indian stock market and consult with a qualified financial advisor before making any investment decisions.