Primary Market – Meaning, Types and Function

What is the Primary Market?

The primary market is a part of the capital market. It enables the government, companies, and other institutions to raise additional funds through the sale of debt and equity-related securities. For example, primary market securities can be notes, bills, government bonds, corporate bonds, and stocks of companies.

What are the Features of the Primary Market?

The primary market is a type of capital market that deals with the new issue of stocks and securities. The main functions of a primary market include origination, underwriting and distribution. Origination is to identify, assess and process new securities for the issue. Underwriting is when a banking institution acts as a middle man between issuers and investors. The primary market offers underwriting services. And distribution refers to selling stocks and new securities to investors. Following are the features of the primary market:

• The primary market deals with the new issue of securities. Any share, bonds, ETF or any marketable security, is first introduced in the primary market.
• Unlike the secondary market, the primary market has no physical existence, which exists in the form of stock exchanges.
• Security is floated on the primary market before going to the secondary market. Hence it precedes the secondary market.
• There are different methods of raising capital in the primary market; namely, IPO, offer for sale, private placement, rights issue, and E-IPO.

You may also like to read about the Primary Market vs Secondary Market

Functions of the Primary Market

There are three entities involved in the functions of the primary market. It includes a company, an investor, and an underwriter. Following are the functions of the primary market:

1. New Issue Offer

New issues are issues that have never been traded on other exchanges and are now offered on a primary market. Setting up a new issue market entails a wide range of responsibilities. For example, carefully assessing the project’s viability. Financial arrangements are formed for this purpose and take into consideration promoters’ equity, liquidity ratio, debt-equity ratio, etc.

2. Underwriting 

When launching a new issue, underwriting is crucial and necessary. If the firm is unable to sell the required number of shares, underwriters are in charge of purchasing unsold shares in the primary market. Financial institutions that take on the role of underwriters can receive underwriting commissions. Investors analyse underwriters and decide if taking the risk of investing in the issue is worthwhile. Also, it is quite possible that the underwriter buys the entire IPO issue and subsequently sells it to the investors. 

3. New Issue Distribution

Distribution is yet another very important function. To begin the distribution process, first, a new prospectus is issued. Next, an announcement is made to invite the general public to subscribe to the issue. Here, a detailed report of the company and the issue and information regarding the underwrites is made available for investors to assess and analyse the issue. 

The company issues the securities to its investors. The issue can be in the form of a public issue, private placement, rights or bonus issue, and many more. Once the company receives the money, it issues the certificate to the investor. The securities can be issued at face value, premium value or par value. When the issue closes,  securities are traded in the secondary market. The trading in the secondary market can happen on the stock exchange, bond market, or derivatives exchange.

The companies that offer securities are looking for expanding their business operations, fund their business targets, or increase their physical presence across the market. The Securities and Exchange Board of India (SEBI) regulates the primary market.

How do Primary Markets Raise Funds?

The primary market enables companies, government, and other institutions to raise funds through the sale of equity and debt-related securities. Public sector institutions raise funds through bond issues. While, the corporations raise capital through the issue and sale of new stock through an initial public offering (IPO). Furthermore, the other ways to raise funds in a primary market is through Further Public Offer or Follow on Offer or FPO, Private placement, Preferential issue, Qualified institutional placement, Rights issue and Bonus issue.

Types of Primary Market Issues

1. Public issue

The public issue is one of the most common methods of issuing securities to the public. The company enters the capital market to raise money from kinds of investors. Here, the securities are offered for sale to new investors. The new investor becomes the shareholder of the issuing company. This is called a public issue. The further classification of the public issue is –

2. Initial Public Offer

As the name suggests, it is a fresh issue of equity shares or convertible securities by an unlisted company. These securities are traded previously or offered for sale to the general public. After the process of listing, the company’s share is traded on the stock exchange. The investor can buy and sell securities after listing in the secondary market.

3. Further Public Offer or Follow on Offer or FPO.

When a listed company on the stock exchange announces fresh issues of shares to the general public. The listed company does this to raise additional funds.

4. Private placement

Private placements mean that when a company offers its securities to a small group of people. The securities may be bonds, stocks, or other securities. The investors can be either individual or institution or both.

Comparatively, private placements are more manageable to issue than an IPO. The regulatory norms are significantly less. Also, it reduces cost and time. The private placement is suitable for companies that are at early stages (like startups). The company may raise capital through an investment bank or a hedge fund or ultra-high net worth individuals (HNIs)

5. Preferential issue

The preferential issue is one of the quickest methods for a company to raise capital for their business. Here, both listed and unlisted companies can issue shares. Usually, these companies issue shares to a particular group of investors.

It is important to note that the preferential issue is neither a public issue nor a rights issue. In the preferential allotment, the preference shareholders receive dividends before the ordinary shareholders receive it.

6. Qualified institutional placement.

Qualified institutional placement is another type of private placement. Here, the listed company issues equity shares or debentures (partly or wholly convertible) or any other security not including warrants. These securities are convertible in nature. Qualified institutional buyer (QIB) purchases these securities.

QIBs are investors who have requisite financial knowledge and expertise to invest in the capital market. Some of the QIBs are –

 Foreign institutional investors who are registered with SEBI.

• Alternate investment funds
• Foreign venture capital investors
• Mutual funds
• Public financial institutions
• Insurers
• Scheduled commercial banks
• Pension funds

Comparatively, qualified institutional allotment is simpler than the preferential allotment. The reason is they do not attract any standard regulations like submitting pre-issue filings with SEBI. Thus, the process becomes much more comfortable and less time-consuming.

7. Rights issue

This is another type of issue in the primary market. Here, the company issues shares to its existing shareholders by offering them to purchase more. The issue of securities is at a predetermined price.

In a rights issue, the investors have a choice of buying shares at a discount price within a specific period. It enhances the control of the existing shareholders of the company. It helps the company to raise funds without any additional costs.

 8. Bonus issue

When a company issues fully paid additional shares to its existing shareholders for free. The company issues shares from its free reserves or securities premium account. These shares are a gift for its current shareholders. However, the issuance of bonus shares does not require fresh capital.

Explore: Stock Market Basics

Why Do Companies Issue Shares to the Public?

Companies come to the primary market to raise money for several reasons. Some of them are for business expansion, business development, and improving infrastructure, repaying its debts and many more. This helps the company to increase its liquidity. Also, it provides a scope for more issuance of shares in raising further capital for business.

The company can raise capital through –

• Equity: when the company raises money by issuing shares to the public. It is termed as stock capital, also known as share capital of the company.
• Debt: the companies raise capital by taking loans where interest is payable on it.

When a company requires capital, the primary source of funds is loans from banks. However, raising funds from banks requires interest payments to them. Consequently, when a company raises funds from the public, there is no commitment to fixed interest payout.  Also, there is profit-sharing among the shareholders in proportion to the number of shares held by them. There are two ways in which the company shares the profits among its shareholders –

• Dividend Payout
• Capital appreciation

Thus, the money raised in the primary market goes directly to the issuing company. This is where the capital formation of the company takes place.

How to Apply Through an Initial Public Offering (IPO)?

To apply for an IPO, the investor needs to choose for the IPO and apply for it. Next, the investor needs the following accounts –

• Demat account – it is mandatory for an investor to have a Demat account and hold the shares in electronic form.
• Bank account – for making the payment for shares. It is done via Application Supported by Blocked Amount (ASBA) facility.
• Trading account – one can open this account with any of the brokerage firms which offer trading facilities.

The following is the process for applying for an IPO online –

1. Log in to the trading account and select the IPO for investing.
2. Enter the price and number of lots of the shares
3. Fill the application form and provide UPI Id.
4. Approve the funds request through the UPI app
5. Application is successful.

Once the issue closes, the company determines the share price and allot shares. After 15 days, the share allotment happens to the investors. If the investors receive the shares, the amount is deducted from the bank account.

After the allotment process, investors receive a Confirmation Allotment Note (CAN). The shares are visible in the Demat account. In case, the investors do not receive the allotment, the amount blocked is released back to them.

Finally, the shares issued during the IPO are listed on the stock exchange and available for trading.

Explore What are Preference Shares?

Concepts Related to the Primary Market

Offer document

The offer document means prospectus.  This document covers all the relevant information about the company. The data is about the company, its promoters, the project, financial details and past performance, objects of raising money, terms of issue, etc. This helps the investor to make their investment decision.

Companies issue offer document while raising capital from the public. Companies issue offer document in case of a public issue or offer for sale. For a rights issue, a letter of offer is issued. The company files the offer document with the Registrar of Companies (ROC) and stock exchanges.

Price band

The price band of an IPO is the offer price of the company’s shares. The lead manager decides the price band for any IPO. There is no specific or standard calculation for it. It is determined by looking at the company’s valuation and prospects. The company announces its price band, and then investors make their bid. Once the company receives the requests, it decides a particular price for the listing of shares.

For example, the IPO of an XYZ company opens on 20th September 2019 and closes on 23rd September 2019. The company fixes the share price band at Rs.1000-Rs.1010.

The spread between the floor price and the cap price shall not be more than 20%. The price band can be revised. If the price revises, then the bidding period also extends for three more days.

Cut off price

A cut off price is any price that an investor can bid. In other words, the investor is ready to pay whatever price the company decides at the end of the book-building process. The retail investors pay the highest price while placing the bid at cut-off price. If the company chooses the final price lower than the highest price, the remaining amount is returned to the investor.

The company’s employees are eligible to bid in the employee reservation portion. Also, the retail investors are allowed to bid at the cut-off price. However, QIBs (including anchor investors) and non-institutional investors are not allowed to bid at the cut off price.

Floor price

The floor price is the lowest price in the share price band. It is the price at and above which investors can place their bids. On the other hand, the highest price in the price band is called the cap price.

For example, the IPO of an XYZ company opens on 20th September 2019 and closes on 23rd September 2019. The company fixes the share price band Rs.1000-Rs.1010. Here, the lower end range that is Rs.1000 is called as the floor price. This is the minimum price at which IPO is issued. On the other hand, the upper limit of the price band is Rs.1010, which is the cap price or maximum price.

Face value

The face value of a share is the value at which the share is listed on the stock market. Face value is also called par value. The face value is determined when the company issues shares to raise capital. Hence, one cannot calculate the face value. It remains fixed and never changes. However, if a company decides to split the shares, then the face value can change.

Mostly, Indian company shares have a face value of Rs.10. The face value is significant in the stock market for legal and accounting reasons. When a shareholder buys a stock, the company issues a share certificate that has face value mentioned.

To conclude, when an investor decides to invest in the stock market, they need to keep an eye on the primary market too. Also, the investors do a thorough study of the company they select to invest in. One needs to study the company’s financials, its past performance, reasons for raising capital, etc.  The reason is IPOs have a great potential to offer returns to investors. One needs to understand the concepts related to the primary market to help them invest better. 

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