If you have been actively investing in the stock market and are regular with trading with your demat account, you have surely heard of something called an Initial Public Offering (IPO). An upcoming IPO is when a company first sells shares of its stock to the public. But here’s the thing: there are different ways that companies can decide how much to charge for those shares. One way that’s becoming more popular is called book-building.
What is the Book-Building Process in an IPO?
Book-building in an IPO is a process which helps companies figure out what price to set for their shares when they first go on sale. It’s a bit like a “build your own” menu at a restaurant. The company sets a price range, and then investors can indicate how many shares they want to buy at different price points within that range. Based on the demand from investors, the company can then determine the final price for the shares.
There are a few different types of book-building, but they all work similarly. The main advantage of book-building is that it can help ensure that the shares are priced fairly based on what investors are willing to pay for them. This is different from the traditional method, where the company sets a fixed price for the shares regardless of what investors might be willing to pay.
Step-by-Step Book-Building Process
Step 1: Appointing an Underwriter
The process kicks off by hiring an underwriter, typically an investment bank, which aids the company in determining the size of the issue and the pricing range. This range sets a floor and ceiling for the share price. The underwriter also assists in drafting the Draft Red Herring Prospectus (DRHP).
Step 2: Building the Book
The underwriter aggregates the data. Using a weighted average method, the final cut-off rate, or price, is determined based on market demand.
Step 3: Publicising Information
To ensure transparency, bid information is made public on stock exchanges. This step enables the general public to make informed decisions.
Step 4: Final Allocation
Shares are allocated to investors whose bids were accepted. Investors bidding above the cut-off price receive surplus money, while those bidding below must settle the difference.
Distinguishing Book-Building from Fixed Pricing
Distinguishing book-building from fixed pricing can be quite tricky, but it’s an important distinction to understand. In book-building, the price of an initial public offering (IPO) is determined through a process of gathering expressions of interest from potential investors. The underwriter then sets a price range for the shares, and investors submit bids within that range. The price is ultimately set at the highest price at which all of the shares can be sold. So here is how to begin.
Price Disclosure:
While fixed pricing reveals the upcoming IPO price in advance, book-building computes prices based on investor demand.
Bidding:
Fixed pricing binds investors to purchase shares at the set price, whereas book-building allows bidding within a specified price range.
Efficiency:
Book-building is deemed more efficient as prices are determined by market demand, providing a realistic valuation.
Advantages
- Intrinsic Value Discovery: Helps in deciding the prices of securities and determining the inherent value of shares.
- Quality Investor Selection: Allows issuing companies to choose quality investors based on bids.
- Cost Savings: Saves funds as marketing and advertising expenses are reduced.
- Rational Price Determination: Facilitates a sensible pricing strategy by considering market demand.
- Enhanced Transparency: Publicising bidding information fosters transparency.
Conclusion
The book-building process is an important method that companies use to dynamically set prices for their IPOs. Investment banks, also known as underwriters, often assist in this process. This approach aligns with the preferences of stock exchanges and provides a higher level of transparency to the public. For beginners who are entering the world of demat trading, it is important to understand these terms so that they can make informed investment decisions. Read more blogs on our website.