A company or business issuing its shares in the public capital market has to go through the Initial Public Offering (IPO) process. At the end stage of the process, when the issue is subscribed, companies employ different methods for price determination before allotment.
Based on price discovery methods, there are two types of IPOs: a fixed-price IPO and a book building IPO. Under the former method, the price of an IPO is fixed by the company in advance. On the other hand, the method of price discovery is entirely different under the book building process.
Read on to know more about how companies discover the share price of an IPO through book building.
Book building is a process by which companies, with assistance from underwriters or investment banks, determine the price at which shares in an IPO are to be sold. It came into being in 1995.
Under the IPO book building mechanism, the share prices are determined based on a transparent bidding process. Investors can invest in IPOs at any rate within the price band disclosed to them in the prospectus.
In this method, you only have to pay the application fee at the time of bidding. The entire amount will be deducted from your account only after the allotment.
Before investing in any IPO, you must be aware of the process of book building and how the prices of an issue are determined. Under the book building mechanism, price discovery is done in five steps. Here are these five book building process steps:
The first step in the book building process involves hiring an underwriter or an investment bank.
An underwriter helps the company to determine the issue size, decide on the price range, and prepare a Draft Red Herring Prospectus.
In the second step, different types of individual and institutional investors are invited to bid for the IPO securities. It’s crucial that these investors own an active Demat account. Companies generally open the bidding window for their IPOs for three days.
As the company and underwriter receive bids from investors, they analyse the data to assess the aggregate demand. Using the weighted aggregate mechanism, the underwriter comes to a final issue price, referred to as the cut-off price.
To ensure transparency, stock exchanges require companies to publish information on investor bids.
Finally, based on the level of IPO subscription and cut-off price, the company will make you an allotment and settle the remaining balance, if any.
There are two types of book building processes in an IPO. Here are some details to keep in mind:
Under partial book building, the investment banker invites bids only from selected investors. Using the average weighted bid mechanism, a cut-off price is determined, which is considered a fixed price for retail investors in the later stage.
Companies that urgently require funding adopt an accelerated book building approach. Under this mechanism, the company contacts multiple investment banks and goes ahead with the bank that offers the highest backstop price.
The contracted underwriter then requests bids from other institutional investors to offload its ownership in the company.
The book building method allows large companies to enjoy the following benefits:
Efficiency: This approach is far more efficient than fixed-priced IPOs because the offer price is determined based on the demand
Transparency: In the book building approach, companies disclose all the bidding information, making the process more transparent than fixed-priced IPOs
Lower Costs: The book building method is an inexpensive price discovery method and reduces paperwork, advertising and brokerage costs
Accuracy: When a company sets an IPO price, shares can be overpriced or underpriced; book building ensures it remains close to the actual price
Companies opting for the book building method must be aware of the Securities and Exchange Board of India (SEBI) regulations. For instance, a company can opt for the book building method for 75% to 100% of IPO shares.
As its name suggests, in 100% book building, the price of all shares for the issue is determined through this process. On the other hand, if a company chooses to go ahead with 75% book building, the price of 25% of the shares of offer will be determined in advance.
Keep in mind that book building in IPOs is today considered the ideal way to price securities. That being said, it does not work for companies that are not well-known or have minor issues planned.
In most cases, the book building process of an IPO is considered better than a fixed-priced method. This is because the latter has a higher chance of being overpriced or underpriced. On the other hand, the book building method is more transparent.
The book building process tries to ensure that an IPO is correctly priced. However, this system is far from perfect, and there always remains a risk of being underpriced or overpriced.
No, the book building process for determining IPO prices is more suitable for large companies.
The bid price refers to the amount an investor is willing to pay for a lot containing a certain number of shares during the IPO subscription.