Last Updated on November 8, 2023 by BFSLTeam BFSLTeam
One of the many ways for organizations to raise capital is through issuing their shares to the general public. Book building is a key aspect of this process, and this article elaborates on its methodology.
What is the Book Building Process?
Whenever a company first lists its shares in the stock market for an Initial Public offering (IPO), they need to decide on what price it will offer these shares to the general public. Issuing organizations can determine the price in two ways:
(i) Fixed Rate Issuing and
(ii) Book building methodology.
While following the fixed rate issuing, the company can pre-decide the share price for its IPO. On the other hand, the book building process follows a different methodology to arrive at the offer price. Let us understand how it works.
In simple terms, the book building process helps the issuing company decide its share price for the IPO by analysing the demand for its shares. Companies execute this with the help of Financial Institutions, such as Investment Banks – known as underwriters in this process. When a company decides to offer an IPO using this methodology, it procures bids from selected investors to analyse these bids and gauge the demand for their shares. The company further processes this data to determine the price of its shares. The process is known as book building because the underwriter maintains a book built over time by analysing the bids received from various potential investors.
Know How Book Building Works
The book building process comprises five levels, as explained below:
- Shortlisting and finalising an underwriter- The primary step for any company planning to issue an IPO is to find an underwriter who can provide the proper guidance with their expertise. An underwriter is usually an Investment Bank that helps the issuing company determine their issue size and share price range, create the Draft Red Herring Prospectus (DHRP), etc. The underwriters are closely involved in the entire IPO process and carry out the book building.
- Solicit bids from investors- This step lays out the foundation for the book building process wherein the underwriter invites selected large-scale investors to bid for the upcoming IPO. These investors are a mix of high-net-worth individuals, hedge funds, fund managers, etc. The bidding process gauges the number of shares the investors are willing to purchase and the amount they bid for. The underwriters also provide the price range within which the investors can bid.
- Book building- At this stage, the underwriters have all the data they need to carry out the book building process and determine the price the issuing company can offer their shares for. The investors who bid for the shares may offer different prices and quantities per their analysis and requirements. The underwriter aggregates this data, and the cost is estimated using a weighted average methodology. The result is a “cut-off” price that the underwriter suggests to the issuing company to price their shares.
- Making the information public- At this stage, the underwriters have provided all the information the issuing company sought. The next step involves meeting the regulatory requirements set by the regional and international Stock Exchanges. The issuing company discloses all information relating to the bidding process to the general public. It is mandated across Exchanges to keep the process transparent and help the general public make investment decisions.
- Allocating the shares- The company allocates shares to investors who applied for their IPO. The bidders who bid for a higher price than the cut-off price get a refund of the excess amount. Similarly, the bidders who bid lower than the cut-off price need to pay the difference to get their allotted shares. It is important to note that not all investors are allotted shares in case of an IPO that is oversubscribed.
The Book building process can be of two types:
- Accelerated Book Building- There are times when the issuing organisation needs funds and taking debt is not an option. During such times, the book building process cannot accommodate different bids due to time constraints. The process is carried out quickly by using auctions instead of bidding. The highest price received during the auction is awarded the contract.
- Partial Book Building- Inviting bids is further restricted under this type of book building. Only a few selected lending organisations may be involved in the bidding process. The underwriters use their data to determine the cut-off price for the general investors. Partial book building can be cost-effective and also efficient at the same time.
Conclusion
The book building process helps the issuing company find the intrinsic value of their shares before finalising their offer price. It also benefits the company by allowing them to invite selected investors and logically determine their offer price by gauging the demand and analysing the bids received. On the other hand, the process also benefits the investors since the company must disclose all the bidding-related information, making the process very transparent. Overall, the process is considered highly efficient compared to other methods of arriving at the offer price and is also preferred by the stock exchanges.
