Companies all throughout the world price their shares using either fixed pricing or book building in IPO. The fixed price technique has become obsolete over time, and book building in IPO has become the de-facto process for pricing shares during an initial public offering. In this post, we’ll look at how the book-building process works, or how IPO shares are priced.
What is Book Building in IPO?
In the stock market, book building is a price discovery process employed when pricing securities for the first time. When shares are offered for sale in an IPO, they might be sold at a set price or at a variable price. If the corporation is unsure about the exact price at which to sell its stock, it might set a price range rather than a specific sum. The book building process is the method of determining the price by giving investors a price range and then allowing them to bid on it.
It is regarded as one of the most efficient primary market processes for pricing securities. This is the preferred way, which is supported by all major stock exchanges and, as a result, is used in all major developed countries.
Process of Book Building
The following is a full description of the book-making process:
Investment Banker Appointment
The appointment of the head investment banker is the first stage. Due diligence is carried out by the main investment banker. They recommend the size of the capital raise that the company should undertake. After that, they suggest a price range for the shares to be sold. If management agrees with the investment banker’s recommendations, the prospectus is issued with the price range recommended by the investment banker.
The floor price is at the low end of the price range, while the ceiling price is at the high end. The cut-off price is the ultimate price at which securities are offered for sale following the complete book building process.
Bids are collected from market participants who want to buy the shares. They must bid on the number of shares they are willing to purchase at various price levels. The investment bankers are intended to receive these bids as well as the application money. It should be highlighted that no investment banker is involved in the bid collection process. Instead, the main investment banker can select sub-agents to tap into their network to receive offers from a bigger group of people.
After the main investment banker has gathered all the bids, they begin the process of price discovery. The ultimate price is just the weighted average of all the bids that the investment banker has received. The cut-off price is set at this level. The ceiling price is usually the cut-off price for any subject that has garnered significant media attention and is widely anticipated by the public.
Companies are required to make public the specifics of the bids they received by stock exchanges all over the world in the interest of transparency. It is the responsibility of the lead investment banker to publish advertising for a set amount of time (let’s say a week) containing details of the offers received for the purchase of shares. Many markets’ authorities have the authority to physically verify bid applications if they so desire.
Finally, the application amount received from the various bids must be adjusted, and shares must be distributed. For example, if a bidder offers a lower price than the cut-off price, a call letter must be sent requesting the balance payment. If a bidder’s price is higher than the cut-off, a refund check must be issued to them. The settlement process assures that investors only receive the cut-off amount in lieu of the shares sold to them.
You may also read about: What is Face Value in IPO?
Partial Book Building
Another variation of the book building method is partial book building. Rather than accepting bids from the broader public, investment bankers invite bids from a select group of significant institutions. A weighted average of the prices is calculated based on their bids, and a cut-off price is determined.
The individual investors are then offered this cut-off price as a fixed price. As a result, only institutional bidding takes place, rather than retail bidding.
This is also a good way to find out about prices. In addition, the expense and complexity of conducting a partial book building are minimal.
What makes book building in IPO superior to the fixed price mechanism?
To begin with, the book building process allows for greater flexibility in IPO price. Many IPOs were either under-priced or overpriced prior to the emergence of book building. This caused issues because the corporation would lose potential funds if the issue was under-priced.
If the issue was overpriced, however, it would not be fully subscribed. In fact, if it received less than a certain percentage of subscriptions, the securities issuance would have to be cancelled, and the enormous costs paid would have to be written off. Such incidents no longer occur because of the book building process, and the primary market operates more efficiently.
Other Aspects of IPO Pricing
There are a few more elements at play that could cause the outcome to differ from what the markets predict. Several recent IPOs have used a purposeful under-pricing strategy, resulting in oversubscription and a significant surge on the first day of trading.
This is commonly done to increase demand, but it can also be done to create buzz and influence the thoughts of investors and institutional finance firms. It’s a way to celebrate a stock’s debut by throwing a party on the first trading day.
It is preferable to see stocks surge on their first trading day rather than have them contract. To earn good listing gains, promoters and bankers tend to under-price their securities in general.
Understanding the nuances and difficulties of book building is critical to getting the most out of your IPO investment.
Understanding the goal of an IPO requires delving deep into the prospectus, process, and mindsets of promoters and bankers, which is an art developed through experience.