The Primary Market: Where Securities Are Created

The primary market is where a security is created and sold for the first time. A primary transaction is the only route by which money paid for a company's shares can reach that company. Once a share exists, selling it sends the issuer nothing, whoever the buyer is. Creation is occasional and trading is continuous. Most people carry the opposite picture.

Most people meet the share market from the outside, through a price on a screen, and the picture they build from it is of one continuous place where shares are bought and sold all day. The screen picture is missing a step, and the missing step is the one that produced everything else on the screen. Before any share can be bought, somebody had to make it. Making it is a separate transaction, with a different seller, a different destination for the money, and a rhythm nothing like the daily one.

The definition of a share, and what a holder of one actually holds, is settled material, as is what each of the corporate actions does to a share count: the split, the bonus, the offer made to existing holders and the further issue placed with new ones. One test, applied in about four seconds, sorts every corporate action and every ordinary day of trading into two piles. Which pile a transaction falls into is decided by one question, and everything that follows is a consequence of the answer.

What makes a transaction primary?

Here is the test. Two lines carry it, and everything below is a consequence of one or the other. A transaction belongs to the primary market when either of two things is true. Either the security did not exist before the transaction, or the seller of the security is the issuerThe company, or other body, whose obligation the security represents. A share is an obligation of the company that created it. That company is the issuer of the share and stays the issuer for as long as the share exists. itself.

Two limbs, and most transactions satisfy both or neither. Sarvani Coatings Limited creates a crore of new shares and sells them to buyers: those shares did not exist an hour ago, and the seller is Sarvani Coatings Limited. Both limbs. Now a person sells four hundred Sarvani Coatings shares to somebody who wanted four hundred: the shares existed this morning, and neither of the two parties is Sarvani Coatings Limited. Neither limb, so the transaction belongs to the other pile.

The second limb is there for the awkward case, and it is worth understanding rather than memorising. A company can create a security and not place it with anybody straight away. The security then exists, and the company is holding it. When the company later sells that security, nothing is being created, and yet the money still reaches the company. One side of that transaction is the issuer, so nobody would call it a sale between two investors. The second limb catches exactly that case and stops the definition arguing with itself.

Now the shorter version, and the one in everyday use. Money paid for a security reaches the issuer only in a primary transaction, and never in any other one. That sentence is the whole test in a form that can be applied without knowing anything about the paperwork. The test does not say the money always moves. One kind of primary event moves no money at all, and that case is worked through below. The claim is stronger and more useful than that: wherever money does change hands, its destination settles which pile the transaction belongs to.

What actually happens when a security is created?

Watch the order of events. The order is what makes the two records move together. First the company decides to issue, on stated terms: how many, of what kind, at what price and to whom. Then the securities come into existence on those terms. Then they are allotted. Allotment attaches each one to a named buyer rather than leaving it floating unattached. Then the buyers pay. Four steps, and the third and fourth are the ones a reader can see afterwards in the published record.

AllotmentThe step at which newly created securities stop being a decision and start being somebody's property. Until the allotment, an applicant has applied; after it, a named person holds a stated number and appears in the register. is the moment the share count changes. Payment is the moment the cash balance changes. In an issue for cash the two happen within days of each other and belong to the same event. A share count rising and a cash balance rising are two views of one thing, and a reader who sees only one of them should go looking for the other.

The money itself splits when it lands. Sarvani Coatings Limited's shares carry a face valueThe nominal amount attached to a share when it was created, written on it and used for the company's own capital accounting. Face value is not what the share is worth and not what anybody paid. Sarvani Coatings Limited's shares carry Rs 2/- of it against an illustrative market price of Rs 486/-. of Rs 2/- each. If the company were to place 1.20 crore new shares at Rs 460/- each and collect Rs 552 crore, only Rs 2/- of each Rs 460/- would be added to share capital, being Rs 2.4 crore in total. The other Rs 458/- a share, Rs 549.6 crore of it, would go to securities premiumThe part of an issue price that sits above face value, held in its own reserve on the balance sheet. The premium is money the company actually received, and it can be large: on a Rs 460/- issue of a Rs 2/- share, Rs 458/- of every Rs 460/- lands here.. Both lines are the company's own money and both sit inside net worth. Nothing about that split changes how much came in, and a reader who looks only at share capital will badly understate what was raised.

Who receives the money, and where does the clean line bend?

The two piles have been clean so far. Here is the place where they are not. Slow down for it: this is the most common route by which a reader credits a company with money the company never saw.

A company going out to buyers can put two quite different things inside one offering. The first is a fresh issue: shares created for the occasion, sold by the company, paid for to the company. The second is an offer for sale: shares that already exist, belonging to people who already hold them, offered to the same buyers at the same time and usually at the same price. From where the buyer stands the two are indistinguishable, and the buyer has no particular reason to care. The money is not indistinguishable at all.

A builder is finishing a block of flats. Twenty unsold flats go on the market and the money funds the next block. In the same brochure, on the same morning, four people who bought flats in the earlier block put theirs up for sale too. One brochure, one price list, one set of buyers walking through. Twenty flats' worth of money builds something and four flats' worth lands in four people's bank accounts, and the brochure cover does not reveal the split.

Take the two hypotheticals sitting in Sarvani Coatings Limited's own record and set them beside each other. In the first, the company places 1.20 crore newly created shares at Rs 460/- and Rs 552 crore arrives in the company. In the second, the promoter group sells 0.312 crore of the shares it already holds at the illustrative Rs 486/-. That comes to Rs 151.63 crore, and every rupee of it goes to the promoter group. Both are sales of Sarvani Coatings shares to investors. Only one of them is a receipt for Sarvani Coatings Limited.

Now imagine those two arriving in one document on one morning. An offering carrying both a fresh issue and an offer for sale looks exactly like that from outside. The headline would read Rs 703.63 crore. Of that, Rs 552 crore reaches the company and Rs 151.63 crore reaches the selling holders, and the only way to know is to read the split rather than the headline. An offer for sale travels inside a primary offering while being, in economic terms, a secondary transaction, and this is the one place where the clean line genuinely bends.

What kinds of transaction happen in the primary market?

Five shapes cover almost everything, and they differ in who is allowed to buy rather than in what happens underneath. In each of the first four, shares are created and somebody pays for them. In the fifth, shares are created and nobody pays for anything. The fifth shape is on the list for exactly that reason.

A placementAn issue of new securities to a chosen group of buyers rather than to the public. The company approaches a limited set of institutional investors, agrees terms with them and issues to them, without an offering open to anyone who applies. and a public issue create shares in exactly the same way, and the difference is who was in the room. A rights offer is the same again, except that the room contains only people who already hold shares, and each of them gets an entitlementThe right, given to an existing holder in a rights offer, to buy a stated number of new shares at the offer price. An entitlement is a right rather than an obligation, and where it can be sold on, a holder who does not want the new shares can pass it to somebody who does. sized to what they already hold.

The bonus issue is the interesting one. Sarvani Coatings Limited's one for one bonus at the end of year one created 12.00 crore new shares and took the count from 12.00 crore to 24.00 crore. Every holder woke up with twice as many shares. Nobody applied, nobody paid, and Sarvani Coatings Limited's cash was exactly where it had been the day before. The only thing that moved was an amount inside the company's own reserves, shifted from one line to another so that the newly created shares had capital standing behind them. A bonus issue is a primary event that raises nothing at all. Creating securities and raising capital are two separate ideas that merely travel together most of the time, and the bonus is the cleanest proof of it.

How is a price arrived at when nothing has traded yet?

Every price used so far was borrowed from somewhere. The illustrative Rs 486/- is what Sarvani Coatings Limited's shares were changing hands at on the stated date. The hypothetical rights issue at Rs 350/- and the hypothetical follow-on at Rs 460/- are both set against that number, one well below it and one a little below it. Pricing against a traded number is the easy case, and it covers most primary transactions a listed company ever does: a price already exists, the issue is priced at some distance from it, and everyone arguing over terms is arguing about the size of the distance.

The hard case is the first one. Before a company's shares have ever traded, there is no number to argue from. Nobody has ever had to reveal what they would pay, so nobody has. The price cannot be observed, so it has to be established, and that means a process rather than a calculation: the company and its advisers go out to prospective buyers, collect what each says it would pay and for how many shares, and arrive at a price out of what comes back. The process has a name, book buildingThe process by which a first issue price is arrived at by collecting bids from prospective buyers, each naming a quantity and a price, and building up a picture of demand before the price is fixed. How it runs and what conditions attach to it are covered separately., and it is covered separately rather than here.

Household version. Somebody selling a flat in a building where four flats sold last year is arguing about a discount or a premium to a number everybody already knows. Somebody selling the only house on a newly cut road has no such number, and must ask people what they would pay and see who says what. Where a price already exists the primary transaction is priced against it, and where none exists the price has to be built out of what buyers say they are willing to pay.

Why does the primary market need the secondary market?

Ask the question from the side of the person handing the money over. The answer is on that side. A company wants capital it never has to give back on a date. Capital that never has to be given back is the whole appeal of equity from where the company sits: nothing matures, nothing falls due, and a bad year does not put a repayment in front of a business that cannot make it. Permanent capitalMoney put into a business with no maturity date and no obligation on the business to return it. Equity is the ordinary example. The company never has to repay it, and that single fact makes equity both durable funding and hard to raise. is the phrase for it, and permanence is the feature.

Now the other side of the same transaction. Somebody is asking an investor for Rs 5,00,000/- in exchange for a thing with no maturity, no repayment schedule and no date on which anybody owes that investor anything at all. Put like that, almost nobody agrees, and the few who do are making a different decision from the one ordinary investors make every day.

Those terms are not made acceptable by a promise from the company. The company has not made one. They are made acceptable by the existence of somebody else who will buy the thing off the holder. The company never repays; the holder gets out by selling to the next person, and the next person gets out by selling to the one after that. Permanent capital is only fundable when the person providing it has a way out that does not run through the company, so the primary market cannot function without a secondary market behind it.

A household that puts Rs 5,00,000/- into a cousin's shop has provided permanent capital with no exit: the money is in, the cousin owes nothing on any date, and getting out means an awkward conversation and probably a discount. A household that puts Rs 5,00,000/- into a listed company's shares has provided permanent capital with a daily exit. Same permanence for the business, completely different position for the household, and the whole of that difference is the second market.

What does Sarvani Coatings Limited's own record show?

Sarvani Coatings Limited has 24.00 crore equity shares of Rs 2/- each in issue and, at the end of year three, Rs 312 crore of cash and investments. The count did not start there. Sorting the events that moved it, alongside the two hypotheticals and an ordinary day of trading, does more for this subject than any amount of definition.

Take the split first, the one event on the list that is there to be argued with. The face value went from Rs 10/- to Rs 2/-, and one share became five. The count moved by 9.60 crore shares, a large movement, and yet nothing was created in any sense worth the word: the same holding was cut into smaller parts. The split earns its place because a reader watching only the share count would see a 9.60 crore jump and reach for an explanation involving money, and there is no money in this event anywhere.

The bonus is different in kind and identical in effect on the cash: 12.00 crore genuinely new shares, brought into existence, allotted to holders in proportion, paid for by nobody. Both hypotheticals are different again: each creates 1.20 crore shares and each sends real money into the company, Rs 420 crore in one case and Rs 552 crore in the other.

Now the last row, the one the whole distinction turns on. About 8.64 lakh Sarvani Coatings shares change hands on an average day. At the illustrative Rs 486/- that is about Rs 42 crore of value. Over 250 trading days that is about Rs 10,500 crore, nineteen times the size of the entire hypothetical follow-on offering. Sarvani Coatings Limited receives none of it, on any of those days, and its cash and investments stand at Rs 312 crore before an average day's trading and at Rs 312 crore after it. The company's funding position last moved when the company last did a primary transaction, and the trading screen has nothing to say about when that was.

What does the primary market not do?

Three things, and each of them is something readers routinely expect of it.

The primary market does not set an ongoing price. A primary transaction fixes one price on one day for one batch of securities, and then it is over. Sarvani Coatings Limited's hypothetical follow-on prices at Rs 460/-, and the moment the offering closes that number stops governing anything. The price the shares trade at afterwards is decided somewhere else entirely, by people the company is not in the room with.

The primary market does not provide liquidity. A buyer in a primary transaction has bought something and has no way out of it from the company. The company will not be buying it back on request. The route out is a sale to somebody else, and that route is not part of the primary market at all.

The primary market does not happen continuously. The third of the three surprises people most. Sarvani Coatings Limited did two capital events in year one and nothing since: no issue in year two, no issue in year three, and its year three financing section carries no receipt from any issue of share capital. Meanwhile its shares changed hands on every single trading day of all three years. A company visits the primary market occasionally and lives in the secondary market permanently. Most people picture the two the other way round.