- Book Building Process - How Are Prices of Shares Decided in an IPO ?
- What is Book Building ?
- Book Building
- Book Building Process
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- Book Building Process How to price shares in an IPO
- Partial Book Building
- How is Book Building Better Than the Fixed Price Mechanism ?
- Book building
- Authorship/Referencing - About the Author(s)
Book Building Process - How Are Prices of Shares Decided in an IPO ?
Companies all over the world use either fixed pricing or book building as a mechanism to price their shares.
Over the period of time, the fixed price mechanism has become obsolete and book building has become the de-facto mechanism used in pricing shares while conducting an initial public offer (IPO). In this article, we will study how book building process works i.e.
how are shares priced in an IPO:
What is Book Building ?
Book building is a price discovery mechanism that is used in the stock markets while pricing securities for the first time.
When shares are being offered for sale in an IPO, it can either be done at a fixed price.
However, if the company is not sure about the exact price at which to market its shares, it can decide a price range instead of an exact figure. This process of discovering the price by providing the investors with a price range and then asking them to bid on it is called the book building process.
It is considered to be one of the most efficient mechanisms of pricing securities in the primary market.
This is the preferred method which is recommended by all major stock exchanges and as a result is followed in all major developed countries in the world.
Book Building Process
The detailed process of book building is as follows:
- Appointment of Investment Banker: The first step starts with appointing the lead investment banker.
The lead investment banker conducts due diligence.
They propose the size of the capital issue that must be conducted by the company. Then they also propose a price band for the shares to be sold.
If the management agrees with the propositions of the investment banker, the prospectus is issued with the price range as suggested by the investment banker. The lower end of the price range is known as the floor price whereas the higher end is known as the ceiling price.
The final price at which securities are indeed offered for sale after the entire book building process is called the cut-off price.
- Collecting Bids: Investors in the market are requested to bid to buy the shares.
They are requested to bid the number of shares that they are willing to buy at varying price levels.
These bids along with the application money are supposed to be submitted to the investment bankers. It must be noted that it is not a single investment banker who is engaged in the collection of bids. Rather, the lead investment banker can appoint sub-agents to tap into their network especially for receiving the bids from a larger group of individuals.
- Price Discovery: Once all the bids have been aggregated by the lead investment banker, they begin the process of price discovery.
The final price chosen in simply the weighted average of all the bids that have been received by the investment banker.
Book Building Process How to price shares in an IPO
This price is declared as the cut-off price. For any issue which has received substantial publicity and which is being anticipated by the public, the ceiling price is usually the cut-off price.
- Publicizing: In the interest of transparency, stock exchanges all over the world require that companies make public the details of the bids that were received by them.
It is the lead investment bankers duty to run advertisements containing the details of the bids received for the purchase of shares for a given period of time (lets say a week). The regulators in many markets are also entitled to physically verify the bid applications if they wish to.
- Settlement: Lastly, the application amount received from the various bidders has to be adjusted and shares have to be allotted.
For instance, if a bidder has bid a lower price than the cut-off price then a call letter has to be sent asking for the balance money to be paid. On the other hand, if a bidder has bid a higher price than the cut-off, a refund cheque needs to be processed for them.
The settlement process ensures that only the cut-off amount is collected from the investors in lieu of the shares sold to them.
Partial Book Building
Partial book building is another variation of the book building process. In this process, instead of inviting bids from the general population, investment bankers invite bids from certain leading institutions.
Based on their bids, a weighted average of the prices is created and cut-off price is decided.
This cut-off price is then offered to the retail investors as a fixed price. Therefore, the bidding only happens at an institutional level and not at a retail level.
This is also an efficient mechanism to discover prices. Also the cost and complications involved in conducting a partial book building are substantially low.
How is Book Building Better Than the Fixed Price Mechanism ?
First of all, the book building process brings flexibility to the pricing of IPOs.
Prior to the introduction of book building, a lot of IPOs were either underpriced or overpriced.
This created problems because if the issue was underpriced, the company was losing possible capital. On the other hand, if the issue was overpriced it would not be fully subscribed.
In fact, if it was subscribed below a given percentage, the issue of securities had to be cancelled and the substantial costs incurred over the issue would simply have to be written off. With the introduction of book building process, such events no longer happen and the primary market functions more efficiently.
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team.
MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
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