When a company decides to shift from a private to a public company, it has to sell its shares to the public through the IPO. For the process of listing the shares on the stock exchange, underwriters are hired. These underwriters perform various functions, such as analysing the amount to be raised and the price of the shares to be sold. However, there are cases where underwriters tend to underestimate the demand and set the prices of the IPO issue accordingly. Hence, the IPO issue is underpriced.
Meaning of oversubscription
An IPO is said to be oversubscribed when the number of shares investors/applicants willing to buy surpasses the number of shares that are listed on the stock exchange. Simply, the demand is more than the supply.
Let’s understand it with an example.
For example, X ltd lists 10,000 shares on the stock exchange for the first time. But, later, it was discovered that the demand for shares among the investors was 1,00,000 shares. We can say that the issue was oversubscribed ten times.
Here, the demand for shares among investors is more than the supply; hence, the oversubscription happened. In such cases, the issuing companies usually increase the prices of the shares. Underwriters may also perform the greenshoe option.
How do companies deal with the situation?
As per the Securities Exchange Board of India (SEBI), companies cannot reject applications directly. They can only reject applications in extreme cases, such as in the absence of requirements documents, incomplete information, and submission of incorrect application amounts.
There are 3 ways through which companies can deal if the demand for their IPO is greater than the supply. Let’s have a look at each one of them.
1) PRO-RATA allotment
In pro-rata allotment, none of the applications is rejected. Instead, all the applications of all the applicants are accepted on a pro-rata basis. This means the applicants will not receive the number of shares they applied for. But they will receive shares in the ratio - the number of applicants/the number of shares issued.
Let’s understand it further with an example. Suppose that A company decides to sell 50,000 shares through the IPO to the public. However, the applications are received for 1,00,000 shares. Now, A company will not reject any application. It will allow shares to investors in the ratio of 2:1 (1,00,000:50,000). This means that the applicants that applied for 2 shares will now get 1, i.e. half of what they applied for. This is a pro-rata allotment.
2) Rejecting applications
As mentioned earlier, SEBI does not allow companies to reject applications outright. But the applications with flaws like incomplete or incorrect information provided by the applicants, wrong amounts submitted etc. can be rejected. The money received with applications is usually returned in this case.
For example, a company issued 1,00,000 shares in its IPO. But the actual applications were received for 1,40,000 shares. In this case, 40,000 applications with the abovementioned flaws can be rejected, and money is returned.
3) Pro-rata + rejecting applications
This case applies when the companies can not reject applications due to no flaws in them. In that scenario, the companies accept applications that have been received first fully. The remaining applications are sorted on a pro-rata basis.
UNDERSUBSCRIPTION
Undersubscription is when shares of a company in the IPO are undersubscribed by the public. Meaning the number of shares subscribed/applied by the applicants is less than what is offered in the IPO.
As per SEBI, a company has to fulfil the requirements for the minimum subscription. The minimum subscription set by SEBI is 90%, meaning that out of the total number of shares offered, at least 90% of them must be subscribed by the public. If that doesn’t happen, the company can not start with the allotment of shares.
What are the differences between the two types of subscriptions?
Meaning:
Undersubscription refers to the situation when the demand for shares for a company’s IPO is less than the supply. This is a state when the number of shares applied by the public is less than what is offered in the IPO.
Over-subscription is when the demand for shares for a company’s IPO is more than the supply. This is a state when the number of shares applied by the public is more than what is offered in the IPO.
Minimum subscription:
In a scenario where shares of a company in the IPO are undersubscribed, the company has to ensure the minimum subscription requirement is fulfilled. However, in the other case, there is no point in the minimum subscription as shares are already overly subscribed.
Refund/Adjustment:
When shares of a company are undersubscribed in the IPO issue, no refund or adjustment of funds is required as no excess money is received. However, when the issue is overly applied, the excess money is refunded, adjusted or a combination of the two is exercised.
Approval of the applications
All the applications are accepted in case of under-application of the shares. In case of oversubscription, a few of the applications received have to be rejected.
Issued capital
In the undersubscription of shares of the IPO issue, the company’s share capital amount in the balance sheet is less than the company’s issued capital. However, in oversubscription, the company’s share capital amount in the balance sheet is equivalent to the company’s issued capital.