There are two ways through which companies can fix or decide the prices of the IPO: Fixed pricing issue and the book-building method. In fixed rate issuing, the prices of the shares to be sold to the public in Initial Public Offering are decided in advance by the issuing company. However, the scenario with the other technique is different.
In this guide, we’ll learn what book-building is, what the procedure looks like, what its types are, what the major differences between these two pricing techniques are and a lot more.
What is a IPO Book-building?
If we define the concept in layman's language, it is simply the strategy of deciding the pricing of shares based on their demand. The cost of shares is determined with the assistance of merchant banks. When a company is raising funds through this method, the pricing of shares for the general public is decided by analyzing the bids from other investors. Other investors can be foreign portfolio managers, qualified institutional investors, etc. An underwriter may be hired for the purpose.
The procedure is called so because here, the underwriter creates or builds a book after looking at the prices bid by the institutional investors. After the bidding process is done, based on demand in the market, using the weighted average method, the final cut-off rate is determined.
Book-building process
The technique is simple. It consists of five major steps. Let’s have a look at each one of them briefly.
Step 1: Appointing an underwriter
The first step includes hiring an underwriter for the firm (usually in the form of an investment bank), as it will assist the company in the further stages of the process. The underwriter will recognize the issue’s size( the number of shares to be issued) along with the pricing range for the issue. The range includes a floor rate(below which the applicants can not submit their bids) and a ceiling rate(the maximum price of the issue). The underwriter is also expected to help with drafting the (DRHP) prospectus.
Step 2: Bidding by investors
The second step of the procedure is to invite investors to bid. Generally, high net worth people, fund managers, etc., are invited to bid on the number of shares they are ready to purchase and the amount they would pay.
Step 3: Building the book
Now, the underwriter is equipped with the bids from all the investors. It is expected that different investors would have presented their proposals at different prices. The aggregated demand of the issue is analyzed with the help of all the available data. Using the weighted average technique, the underwriter arrives at the final rates for the issue, which may also be called the “cut-off” prices.
Step 4: Publicize the information
The stock exchanges of various nations have made it mandatory for companies to publicize the information related to the bids that the investors submitted. This is done for the sake of transparency so that the general public can make rational decisions.
Step 5: Final allocation
Finally, the shares of the company's IPO issue are allotted to the investors whose applications got accepted. As you understand, initially, the company gave only a pricing range to investors, so it may be possible that a few investors would have bid at a rate lower than the cut-off price while others might have bid higher than the cut-off price. So, for investors who bid higher than the cut-off rates, the surplus money is paid back to them. At the same time, the investors who bid less than the cut-off rates are asked to settle the difference amounts.
Are there any subtypes of the process?
The following are the two subtypes of it.
- Accelerated book-building: This type is usually preferred when a company needs funds, but debt financing is not an ideal option at that certain point in time. It is usually conducted in the form of an auction rather than bidding. The process is usually completed in a very short period, usually within one or two days.
- Partial book-building process: It is also one of its variants. Here, bids from certain lending institutions are invited and accepted instead of inviting bids from the general public. Then, based on their bids, the cut-off prices are decided, which becomes the final price for retail investors. The costs of this process are low, and its efficiency is high.
Difference between fixed-pricing and book-building
Price disclosure: In a fixed pricing issue, the price is decided before the issue of IPO. Whereas on the other hand, the issue prices of the IPO are not revealed in the beginning. They are computed by looking at the demand of the investors.
Bidding: In a fixed pricing issue, the investors are bound to purchase the shares issued in the Initial Public Offering at the mentioned price only. But in the other method, the bids of the investors willing to purchase the shares issued in the company's IPO are within the pricing range given to them.
Efficiency: This process is more efficient than the fixed price issue method, as the price is determined by analyzing the demand of the issue.
What are the advantages?
Though there are various advantages to the book-building process, some of them are listed below.
- It helps decide the prices of the securities and assists in finding the intrinsic value of shares.
- The issuing company gets to select the quality investors, among others
- The process results in preserving money as funds are spent on marketing and advertising activities are saved
- The price for the shares can be decided rationally by looking at the demand of the same in the market
- As it involves informing the general public about the bidding information, there is a greater sense of transparency
Conclusion
This is one of the crucial ways through which corporations, with the assistance of investment banks who work as an underwriter, decide the price of their IPO issue based on the demand in the market. Stock exchanges prefer this method. It brings transparency to the public.
Frequently Asked Questions (FAQs)
Q. How is the book-building process better than the fixed-price instrument?
It is so because the chances of overpricing and underpricing are high, and there is less efficiency in the fixed-price tool of price determination.
Q. What is 100% book building?
It is a process wherein 100% of the shares are reserved for promoters or employees of the companies.
Q. What is the floor price?
The floor price refers to the minimum amount of the price range at which investors can bid for an IPO. Below this price, applications of the applicants are ignored.
Q. What is the bid price?
The bid price refers to the price that a buyer is willing to pay for a specified number of shares at a certain point in time.
Q. Are there any limitations to the process?
The process has certain limitations, such as the issuer company must be very strong, the process works better in mature market conditions, etc. But still, it is considered more efficient than the fixed-price method and is widely used.