How do companies raise funds to start or expand their businesses? And how do investors get access to new securities and benefit from their growth potential? The answer to all these questions lies in the primary market. It is the market where new securities are created and sold for the first time by the issuers. It is also known as the new issue market, as it offers new opportunities for both the issuers and the investors.
In this blog, we will explore the concept of a primary market along with an example.
What is the Primary Market?
It is the place where the creation and sale of new securities take place. It enables the issuers to raise funds from the investors. This is done by offering them a stake in their business or a claim on their future cash flows.
Imagine you’re at a farmer’s market where farmers are selling their fresh produce directly to customers.
In the stock market, think of the primary market as being similar to those farmers who are selling their goods for the first time.
Thus, new securities like stocks are issued and sold for the first time by companies. These companies do this to raise capital.
They can then use it for various purposes like expanding their business, investing in new projects, or paying off debt.
When a company wants to issue new stocks, it typically does so through an initial public offering (IPO) or a direct listing.
- The investors are the first owners of the newly issued securities,
- They can later sell in the secondary market, where the trading of existing securities takes place.
- The primary market is essential for the economic development of a country. It facilitates the mobilisation of savings and the allocation of resources to productive sectors.
Investors who participate in the primary market by buying these newly issued shares are buying them directly from the company. This is different from the secondary market.
In the secondary market, investors buy and sell shares among themselves. The money exchanged doesn’t go to the company directly.
How Does Primary Market Work
The primary market in India works as follows:
- Company Launches IPO: A company decides to go public and offers its shares to the public for the first time. It is done through an Initial Public Offering (IPO).
- Investor Participation: Investors who want to buy these shares can do so by applying for them through the IPO process.
They do it via application forms, either online or offline.
- Allotment: Once the IPO subscription period ends, shares are allotted to investors. It is based on various factors like demand, company regulations, and market conditions.
- Listing on Stock Exchange: After allotment, the company lists its shares on the stock exchange. This allows investors to buy/ sell these shares on the secondary market.
- Trading Begins: Once listed, the shares start trading on the stock exchange. Investors can buy or sell these shares based on their investment strategies and market conditions.
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- Price Fluctuations: The price of shares can fluctuate due to demand and supply dynamics and company performance. etc.
- Fundraising: The funds raised through the IPO are utilised by the company for various purposes.
Primary Market Example
Let’s consider an example of a primary market activity in India:
Imagine an Indian company, “ABC Pharmaceuticals Ltd.,” decides to go public through an Initial Public Offering (IPO).
ABC Pharmaceuticals decides to raise capital from the public to fuel its expansion plans.
The company hires an investment bank, let’s call it “Capital Advisors India,” to manage the IPO process.
Capital Advisors works with ABC Pharmaceuticals to determine the valuation of the company. This involves analysing the company’s financials, market conditions, and industry benchmarks.
ABC Pharmaceuticals files the necessary documents with SEBI. This includes the Draft Red Herring Prospectus (DRHP) containing detailed information about the company and the IPO.
The IPO opens for subscription for a specific period. Interested investors, both institutional and retail, submit their applications.
Once the subscription period closes, the company determines the allocation of shares. The shares are then allotted accordingly.
After the allotment, ABC Pharmaceuticals’ shares are listed on a stock exchange. This can be the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE).
The shares are now traded in the secondary market. This allows investors to buy and sell them among themselves.
In this example, the primary market activity is the issuance of new shares by ABC Pharmaceuticals through the IPO.
The funds raised from the IPO go directly to the company for its planned activities. And also to investors who participated in the IPO to become shareholders of the company.
Functions of Primary Market
The primary market performs various functions that are beneficial for the issuers, investors, and the economy.
• New Issue Offer: It organises the offer of new securities that have not been traded before.
The new issue offer can be in different forms:
- An IPO
- A follow-on public offer (FPO)
- A rights issue
- A preferential issue, a private placement, etc.
• Underwriting Services: It provides underwriting services to the issuers. Here, an underwriter, usually an investment bank, guarantees the sale of the new securities. He bears the risk of unsold securities.
The underwriter charges a commission or a fee for its services, which is a percentage of the issue size.
• Distribution of New Issue: It facilitates the distribution of the new issue to the investors. This is done through various channels, such as brokers, dealers, agents, etc.
The distribution of the new issue is done with the help of a prospectus. It contains all the relevant information about the issuer, the securities, the financial statements, etc.
Types of Primary Market Issues
The primary market issues can be classified into different types based on the method of issuing and distributing the new securities.
Some of the types of primary market issuance are:
• Public Issue
A public issue is the most common method of issuing securities to the public at large. It can be done through an IPO, an FPO, or a rights issue.
- In an IPO, a company offers its shares to the public for the first time and gets listed on a stock exchange.
- In an FPO, a company offers additional shares to the public after being listed on a stock exchange.
- In a rights issue, a company offers shares to its existing shareholders in proportion to their holdings at a discounted price.
• Private Placement
A private placement means issuing securities to a selected group of investors. This can be institutional investors or high-net-worth individuals without involving the public.
A private placement is faster and cheaper than a public issue. It involves less regulatory compliance and disclosure requirements.
• Preferential Issue
A preferential issue means issuing securities to a specific class of investors. This can be promoters, strategic partners, creditors, etc., on a preferential basis.
A preferential issue requires a special resolution from the shareholders and a disclosure to the stock exchange.
It helps meet the urgent financial needs of the issuer or to improve its capital structure.
• Qualified Institutional Placement (QIP)
Listed companies issue securities to Qualified Institutional Buyers (QIBs) in a streamlined process.
It includes entities like Foreign Institutional Investors and Mutual Funds.
• Rights and Bonus Issues
Existing investors can purchase additional securities at a set price (rights issues) or receive free shares (bonus issues).
This helps enhance control and reward shareholders without additional costs.
Advantages of Primary Market
The primary market offers various advantages to the issuers, investors, and the economy.
Some of the advantages of the primary market are:
• For the issuers, the primary market provides a source of raising long-term funds from a large pool of investors.
The primary market also enhances the reputation and visibility of the issuers. It enables the issuers to reduce their dependence on debt financing.
• For the investors, the primary market offers an opportunity to invest in the new securities of the issuers and share their future profits and growth.
It also provides investors with a fair mechanism for the allocation of securities.
It protects the investors’ interests by ensuring compliance.
• For the economy, the primary market contributes to economic development and growth. The savings are channelled into productive sectors.
It also creates employment and wealth by generating economic activity and enhancing the capital market.
Disadvantages of Primary Market
The primary market has some disadvantages that may affect the issuers, investors, and the economy.
• High Costs: It involves high costs for the issuers. This includes underwriting fees, regulatory fees, marketing expenses, legal expenses, and accounting fees.
These costs reduce the net proceeds of the issue and may affect the profitability of the issuers.
• Overvaluation: It may result in overvaluation of the securities, especially in the case of IPOs. This occurs where the demand may exceed the supply.
This may lead to speculative behaviour and price volatility.
• Risk and Uncertainty: The primary market involves risk and uncertainty for both the issuers and the investors.
The issuers may face the risk of under-subscription or failure of the issue,. This may affect their credibility and financial position.
• Limited Information about the company: Investors may face a scarcity of information regarding the company’s financial performance and future prospects.
Conclusion
Investing in the primary market opens doors to financial growth and opportunity. From providing essential funding for businesses to offering investors a chance to shape their portfolios with new securities, it serves as a catalyst for economic progress.
FAQs | What is the Primary Market
The primary market is where new securities are issued for the first time. It is done by companies or governments to raise capital. The secondary market is where existing securities are traded among investors, such as individuals, institutions, or brokers.
In the primary market, there are four main players: corporations, institutions, investment banks, and public accounting firms. Corporations issue securities to raise capital, while institutions invest capital in these corporations. Investment banks act as intermediaries, facilitating transactions between corporations and investors. Public accounting firms provide services within this market ecosystem.
The secondary market is the market where previously issued securities are bought and sold among investors. The secondary market consists of stock exchanges, over-the-counter markets, and electronic trading systems.
The money market is not a primary market but a part of the secondary market. It is meant for short-term debt instruments, such as treasury bills, commercial papers, etc.
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Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.