What Is IPO Funding? How Does IPO Funding Work in India?

What is IPO funding in India? IPO Funding, or IPO Financing, is a type of funding in which, after fulfilling the necessary requirements, an eligible applicant can obtain financing to raise the funds for an Initial Public Offering. Lenders decide the financing terms. Instead of financing the IPO application entirely with personal funds, the applicant uses the financing facility. The applicant has to pay the financing cost and fulfills the financing obligation irrespective of whether the expected IPO allotment is made.

IPO funding is utilized when an applicant desires to apply for an IPO in the higher amount for which the applicant cannot afford to finance from the cash available to the applicant. It is distinct from the normal ASBA or UPI application, in which the applicant money is blocked in the account and is debited after allotment to the extent required. As per SEBI's Investor booklet, ASBA blocks the application amount in the investor's account until allotment. [1]

This article discusses the IPO funding system in India, the application and financing process, the interest and cost of financing, the implications of partial or no allotment, and the risks associated with financing an IPO in India.

What Is IPO Funding in India?

IPO funding is a feature that allows potential investors to obtain funds to help pay for an IPO application. Financial institutions or other financing providers, as permitted by their policies and regulations, may offer IPO funding.

The idea is straightforward. Imagine an investor wants to apply for an IPO for ₹20 lakh but does not want to fund the entire amount themselves. If the investor is granted an IPO financing facility, the financing provider may lend a portion of that amount, subject to the financing provider’s margin, interest rate, fees, and terms and conditions.

The investor is responsible for the financing cost. If the application is successful and shares are allotted, the financing provider will arrange for the transaction and loan according to its terms. If the application is successful but shares are not allotted, the financing provider may require the applicant to bear the financing cost, while the financing will be released or unblocked.

IPO funding should therefore be viewed as leveraged participation in an IPO, not as a guaranteed way to increase returns.

IPO Funding Step by Step

The steps change according to the provider, but financing usually follows these steps.

1. Select an IPO: The investor evaluates an IPO and decides how much they want to apply for.

2. Check financing eligibility: The investor goes to a financing provider and checks what margin and what credit they will need and what documents they will need to supply.

3. Determine the application size: The investor and financing provider come to an agreement on how much will be funded.

4. Provide own contribution: The investor supplies the margin or funds according to the financing agreement.

5. Arrange the IPO application: The application is done through the ASBA, UPI or IPO application system of choice.

6. Funds are blocked or processed: The application funds are processed under the ASBA and public issue procedure.

7. Allotment is finalised: Shares may be allotted fully, partially or not at all depending on the issue and category.

8. Financing is settled: The financing provider applies the applicable repayment, adjustment and interest terms after the allotment process.

The order and operation of the steps can vary, and the financing agreement should be read, and not just a description of IPO funding.

IPO Funding vs ASBA: What Is the Difference?

One of the most important concepts for beginners is that IPO funding and ASBA are not the same thing.

SEBI's guidance for investors on ASBA states that for an IPO application, an amount is blocked in an investor's bank account and is later debited upon allotment. [1] Therefore, for an IPO application, an investor does not take financing if funds are available to them.

ASBA backed IPO applications do not signal IPO funding in the absence of personal funds.

Who Uses IPO Funding?

IPO funding is generally associated with investors who want to apply for a larger IPO amount and are willing and able to take short-term financing risk. It is particularly relevant to some non-institutional or high-value applicants, depending on the applicable issue structure and financing provider.

However, eligibility is not simply a question of having a Demat account. A financing provider may evaluate factors such as:

• Financial profile and creditworthiness.

• Own funds contribution.

• Requested financing amount.

• Margin requirements.

• Repayment capacity.

• Exposure and obligations.

• Documentation and KYC requirements.

Financing companies may also determine a minimum application size, a limit to financing, interest rates, and a per-transaction fee.

What Drives Investors to Seek IPO Funding?

The biggest draw of financing an IPO application is leverage. Smaller capital pool investors can Cast a bigger application with financing than they otherwise could employ personally.

Imagine an investor has ₹5 lakh to contribute and a financing provider requires a consideration. This investor could potentially apply for an even bigger amount with a financing facility, subject to the provider’s criteria.

The attraction is usually connected to the possibility of receiving an allotment in an IPO that may subsequently trade above the issue price. But this is exactly where the risk begins: the investor is borrowing money before knowing the final allotment or post-listing market price.

A larger application does not guarantee a larger allotment. IPO allocation is based upon the applicable category, demand, the rules and the final basis of allocation.

An Easy Example of IPO Funding

Here is an example of how an IPO might be used if an investor needed to raise ₹15 lakh through the IPO route. Let’s say for this example that a funding provider is willing to fund ₹10 lakh and the investor would need to come up with ₹5 lakh.

Let’s further assume that the application for the IPO does not get any allotment, in which case the investor will not receive any shares. An arrangement for funding implies that the invested capital is either recovered by the financing provider, or is released, but may attract interest, processing fees and/ or other service charges.

If a small percentage of the application is allotted, then the investor receives fewer shares. The financing position then needs to be settled based on the terms of the provider of the financing.

If shares are allotted and the investor sells the shares at a profit, the profit needs to be examined in the light of the financing costs incurred. If shares fall after a listing, the investor may suffer a market loss and still have an obligation to repay the financing provider.

For this reason IPO funding can result in both financial reward and financial pressure being multiplied.

The Effect of Interest Costs on IPO Funding

When it comes to IPO funding, interest is one of the key variables. An investment is looking appealing for an investor if they only consider the potential listing gain. However, the funding must also consider the cost of borrowing.

For the sake of this example, let's say ₹10 lakh is financed at 12% interest per annum for a period of 30 days. The simple interest in this situation will be estimated as:

₹10,00,000 × 12% × 30 ÷ 365 = about ₹9,863

This is a simple example. There are many other ways IPO funding could be structured along with other charges, a different definition of interest, a different minimum interest period, daily interest, other fees charged, etc.

In this example, we assume an investor makes a gross gain of ₹15,000. However, in this case, with interest and other charges estimated at ₹9,863, the net gain will be much less than anticipated.

The same idea applies in this example. If an investment loses value, using financing does not eliminate this loss. The financing charges remain valid per the financing agreement.

What Occurs With an Oversubscribed IPO?

An oversubscribed IPO indicates there are more applicants than shares available. Not every applicant receives the number of shares they wished to buy. There are instances where investors receive zero shares.

For an IPO, oversubscription poses a considerable problem to the investor. An investor may use an outside source to support a large bid, however, there is no assurance of how many shares will be allotted.

An example of this scenario is an investor bids for ₹20 lakhs using external financing and receives shares for only a small fraction of his bid. The financing company manages the rest in accordance with the IPO and financing policies. The investor may still incur the financing cost.

Investors should understand not to assume they will receive shares for the full amount bid.

What Occurs With No IPO Allotment?

SEBI states that in cases of no allotment, the IPO application amount is released through the applicable ASBA or UPI. Amounts remain blocked through ASBA until the time of allotment. The amount necessary for the allotted shares is debited and the remaining portion is released. [1]

In instances of no allotment, the financing company evaluates terms for interest, the minimum billing period, processing cost, and the amount due. Thus, the cost incurred by the investor is not zero.

Understanding the risk of borrowed funds for IPO financing is critical to investors.

What Should You Expect After The IPO Allotment?

Once the final basis of allotment is released, the number of shares allotted to each money investor is known. The shares allotted are settled through the applicable IPO settlement process and the amount corresponds to each allotment.

The financing provider, on the basis of its agreement, may require either a payment or an adjustment. Some financing facilities are estimates based on expected IPO settlement and may have extremely short settlement windows. Other financing facilities may have more favorable terms.

An investor needs to understand the following prior to requesting financing:

• When financing starts to accrue interest

• When financing stops accruing interest

• When the financing principal becomes due

• How partial allotment affects the financing

• What happens if there is no allotment

• If processing or exit financing cost

• What happens if the investor is unable to repay financing

Can You Repay IPO Funding After Listing?

This answer is dependent on the financing contract. Some financing contracts for IPOs give the investor a short window following allotment or a short period of time after listing in which to repay the financing. Other financing contracts will provide more flexibility.

It is a mistake for an investor to assume he or she can hold the allotted shares and wait for the market to increase the price of the shares. If the financing has short terms, the investor may be required to sell the shares at a price that is below the IPO price.

This distinction is very important between an investment and a financing decision. A stock could be a good investment to hold long term, but it could be a bad decision to finance long position.

What Should I Be Concerned about While Opting for an IPO?

1. Market risk

The price of an IPO may fall before it is listed or after listing. Borrowing will not shield you from a market loss.

2. Allotment risk

No assurance exists that the company will allocate to the applicant the number of shares he/she has applied for. A huge number of applications could result in even fewer shares being allocated to the applicant or the applicant being allocated no shares at all.

3. Risk of Interest and Financing

Interest could neutralize capital gain. Processing fees and other expenses significantly increase the break-even point.

4. Risk Due to Financing

Financing may have to be repaid within a specified period. An investor may be under financial pressure for lack of repayment planning.

5. Risk of Liquidity

If the price of the sold shares falls during trading or the liquidity of trading is insufficient, the cash that can be realized will be less than expected.

6. Regulatory and product risk

Rules for IPO applications may change. Investors should trust only the information published by the financing source/SEBI on the latest conditions of financing and permissible structures along with the respective stock exchange and other authorized sources.

IPO Funding & Demat Accounts

A Demat Account is needed to receive shares from an IPO. IPO funding will not substitute for a Demat Account or the usual IPO application process.

The financing process and a Demat Account have different purposes. The financing provider will arrange funds based on their terms, and the Demat account is where securities get credited upon successful allotment.

If you intend to participate in IPOs, you can read more about how to open a Demat account and the importance of a Demat account in investing.

IPO Funding and UPI or ASBA: Why is the Difference Important?

In public issues, UPI and ASBA are two funding mechanisms. Both mechanisms ensure that the amount is blocked, and the applicant does not need to fund the entire amount to the issuer in order to place the bid.

According to the investor information provided by SEBI, investors can apply through ASBA and UPI, as long as the other relevant factors are satisfied. Also, SEBI states in its FAQs that the limit for UPI applications for individual investors is ₹5 lakh, and for retail individual investors it stands at ₹2 lakh. Applications between ₹2 lakh and ₹5 lakh will fall into the applicable non-institutional category provided the other relevant factors are satisfied. [2]

These funding application limits are not comparable to IPO funding limits. A financing provider can mandate its own credit limits, margin requirements and product conditions. Investors need to be aware of the rules for IPO applications and the funding conditions.

Q&A with an IPO Funding Provider

When considering an IPO financing facility, an investor should request the terms and ask the following:

• What do you charge?

• How do you calculate interest? Do you charge interest for at least a specified period? Do you have daily interest?

• How much will you require from me as processing/ document costs?

• What margin/own funds will I require?

• What is the maximum funding I am eligible for?

• What happens to the facility if there is no allotment?

• What if it is only partially allotted?

• When do I need to pay back the loan?

• If the funding stays outstanding, what will be the cost?

• If the IPO is listed below the issue price, what happens then?

• On what basis is the financing provider covered?

Investors should ask to confirm the identity and the regulatory status of the intermediary. SEBI has a list of recognized intermediaries which is published on their website. [3]

When an IPO Funding Lack of Sense

The costs of borrowing to finance an IPO do not warrant a listing when the financing costs are high, the investor is financially constrained, or when the investor is counting on the listing to earn a gain.

Borrowing to fund an IPO to finance an investor’s expected gain from listing also does not make sense when the investor may not receive a full (or even a partial) allotment. An investor’s decision to finance should not be based on the IPO, only on the investor’s capacity to repay.

A useful rule for beginners is simple: if the repayment would become difficult when the IPO does not perform as expected, the amount of leverage may be too high.

IPO Funding Due-Diligence Checklist

1. Read the IPO's offer document and understand what the company is offering.

2. Check the issue price or price band, lot size and application requirements.

3. Understand whether the issue is a fresh issue, an offer for sale or a combination.

4. Assess the company's financials, business model, risks and valuation rather than relying only on listing expectations.

5. Understand the exact IPO financing interest rate and all additional charges.

6. Calculate the financing cost for the expected holding or repayment period.

7. Plan for partial or zero allotment.

8. Plan for a listing below the issue price.

9. Confirm the repayment deadline and consequences of delay.

10. Use only an authorised and properly documented financing arrangement.

For additional IPO education, read our understanding IPO funding and step-by-step IPO application guide. Investors should also review current information from SEBI and the relevant NSE or BSE resources before applying.

Conclusion

With IPO funding, eligible investors are able to use borrowed money to make an application for an IPO instead of using only their own capital. This is achieved by selecting an IPO, obtaining funding from an eligible source, application submission, and subsequently the payment of the funded amount along with the agreed interest charges and other fees.

The use of IPO funding increases financial risk for the investor due to the fact that the investor is using leverage. The investor needs to consider funding costs, the uncertain nature of allotment, the certainty of a funding obligation, and the possibility of an unfavorable outcome incurring a loss post- listing. Just having a larger application does not ensure an IPO allotment or profitable outcome.