Ever been to an auction or seen one, for that matter? If you have, you'd know that the auctioneer comes up with a starting bid price and keeps increasing it unless the richest guy in the room fixes a deal and the hammer is dropped. Anyway, have you wondered how does the auctioneer come up with a minimum bidding price? No, right? Don't you think they'd need to perform some procedures to come up with a bidding range? Well, they have to. The same works with IPOs.
The company has to ensure that the floor limit of the bidding range is low enough to entice prospective investors to invest in the IPO while not compromising with funds required to be raised. And the process followed is called Book Building.
If you have read the prospectus of a company, you would have read about the Book-Building Offer. Nowadays, every company that plans of going public selects the book building method of issuing shares. Let's look at everything essential you need to know about book building.
What is Book Building?
Book Building is the process through which the company discovers the price of its shares when launching an IPO. The company appoints underwriters. The underwriters invite the institutional investors to submit bids for the price at which they are willing to buy the shares. This is what leads to price discovery while launching an IPO.
Generally, this method is followed while launching an IPO as it is an efficient way to determine the price. Here, shares are issued at a price band instead of keeping it fixed. For example, the price band of the recent MTAR IPO was Rs 574-575.
Important Terms used in Book Building Process
Before understanding the process, you should know the key terms which are used frequently in this process:
- Ceiling Price: It is the highest price at which the shares can be subscribed. E.g., If the price band is Rs 500-510, the ceiling price will be Rs 510.
- Floor Price: It is the minimum price at which bids can be made for an IPO. In the above example, the floor price will be Rs 500.
- Cut-off Price: It is the price at which shares will be issued. It is determined based on the demand of prospective investors.
- Price Band: It is the price range between which shares are issued for a subscription. If the book building process is followed correctly, then the price band can be as low as Re 1!
Book Building Process
After understanding the meaning of Book Building, let's look at how this process takes place:
- Appointment of an underwriter: The company appoints an underwriter, generally an investment bank, to determine the underlying value of the share. The underwriter also helps in creating the prospectus and subscribes to the unsubscribed shares.
- Inviting the investors: The underwriter invites prospective institutional investors. They will submit their bids mentioning the number of shares they want to buy and the corresponding price.
- Share Pricing: When the bids are submitted, they are analyzed by the underwriter based on the demand of the shares. After analysis, the underwriter determines the final price at which shares of the company will be issued.
- Transparency: The various details of the bidding process like the bids received, shares subscribed, etc. are publicized to maintain transparency in the process.
- Allotment of shares: Finally, the shares are allotted to the investors at the cut-off price. In case of oversubscription of shares, bids received at ceiling price are given priority. Pro-rata allotment of shares is there. Generally, the people bidding for small quantities are not allotted shares. So, try to subscribe to the maximum shares at the ceiling price if you want to get the shares at any cost.
Other Types of Book Building
Accelerated Book Building: It is preferred by the company when funds have to be raised at the earliest, or the hassle of the entire process is not desirable. In this, the issuing company appoints many investment banks as their underwriters, and the offer period is open only for a day or two. The underwriters approach their network and inform prospective investors about the issue. If everything goes well, the allotment is made overnight, thus enabling the company to raise funds efficiently!
Partial Book Building: As the name suggests, it is the process of following the book building process partially. Here, investment bankers invite only some selected group of prospective investors. It helps in saving cost and time. The weighted average of the prices is calculated based on the bids received, which is used to determine the cut-off price.
Advantages and Disadvantages of Book Building
- It is the most efficient way to discover the price of the share for an IPO.
- The price is determined based on demand, not by the management of the company.
- It is relatively costly, as compared to fixed-price issues like the cost of advertisement, underwriter fees are to be expended.
- It is also time-consuming as a lengthy process is to be carried out to issue the shares.
But the advantages of this process exceed its disadvantages.
If the shares are undervalued, then lesser funds will be collected by the company, whereas the investors to whom the shares were allotted can get massive returns through listing gains.
In the Burger King IPO, the shares were issued at Rs 60 but were listed at Rs 115, leading to a whopping 95% listing gains!
If the shares are overvalued, the IPO may remain undersubscribed. It may force the company to refund the entire proceeds due to the minimum subscription clause, thus defeating the whole purpose of IPO.
So, a company is willing to incur extra costs to avoid such circumstances rather than facing heavy losses.
Book building helps in discovering the price of the shares of a company. The process commences with the appointment of an underwriter who performs the next steps. After getting appointed, they invite bids from big investors regarding the quantity and price of shares to be subscribed. After receiving and analyzing them, the cut-off price of issuing the shares is determined. Then, it is made public to ensure transparency in the entire process. Finally, the shares are allotted to investors who placed bids over the cut-off price.
Accelerated book building is preferred to raise funds from the capital market urgently, where many underwriters are appointed who contact their network for investing in the shares. It is so efficient that allotment can be made overnight, even in favourable conditions. In partial book building, only a small number of investors are invited. The price is finalized based on the weighted average of all bids.
Book building is the most efficient way of price discovery as the price depends on demand, but it leads to more expenditure and time due to a lengthy process. But the advantages overcome the disadvantages as overvaluation or undervaluation of shares may be unfavourable for a company.