What is Book Building?
Initial public offerings (IPOs) are offered at prices as detailed by their underwriters. Book building is the process through which an underwriter comes up with the price for the IPO being publicly offered. The underwriter of the IPO is normally an investment bank and this party determines the price by inviting institutional investors like fund managers to submit their respective bids for the price they would be willing to pay for a certain number of shares.
Hence book building is the means by which an underwriter can determine the overall price at which a company’s IPO will be publicly offered. To discover this price, the book-building process involves generating and keeping a record of investor demand for these shares before the underwriter arrives at their issuance price. Companies often price their IPOs via book building meaning it is seen as a kind of de facto method. It is not only highly recommended by all major stock exchanges, but it is also the most efficient way to price one’s securities.
What is the book-building process?
Book building has become the de facto mechanism through which a company prices its IPO, after surpassing the fixed pricing method. The price is set prior to the participation of investors in the fixed pricing process. Now that we understand the book building definition and purpose, how does it work? Here are the steps that comprise the process of book building.
1. Firstly, an investment bank is hired by the issuing company to serve as an underwriter who is assigned the task of determining the price range at which the underlying security can be priced and thereby sold. The underwriter will also be given the task of creating a prospectus which they will send out to the institutional investing community.
2. Next, the investment bank will invite investors, who are typically large-scale buyers of fund managers. Their individuals will submit bids on the shares they are interested in purchasing by clarifying the number of shares and the amount they are willing to pay for this number.
3. After these bids are submitted, the investment bank evaluates the combined demand for the issue from all the bids that have been received by them. Now it is up to the underwriter to analyze the information by using a weighted average so they can arrive at the security’s final price. This is termed the cut-off price of the security.
4. All the details of the bids that were submitted have to be publicized by the underwriter, for the sake of maintaining transparency.
5. The bidders that are accepted by the company will be allocated their respective shares.
Accelerated Book Building
This is a kind of book building that is employed when a company is in urgent need of securing capital, and debt financing are out of the question. For instance, such is the case when one company is looking to make an offer so they can acquire another company. Be it for short-term protection, or due to owing large amounts of debt, when a company is unable to obtain this requisite financing, it can employ an accelerated book-building strategy. With this tool, the company can instantly obtain financing from the equity market.
The difference between standard book building and accelerated book-building is that, in the latter case, the offer period is open only for one day or two with little to no marketing available. In other words, the time between the pricing of the IPO and the issuance of shares is at most 48 hours. An accelerated book-building process is oftentimes implemented overnight. The issuing company contacts a host of potential underwriters (investment banks) on the evening prior to the placement that is intended.
The issuer of the shares will solicit bids in a process akin to an auction and the underwriting contract will be awarded to the bank that commits the greatest backstop price. The proposal will then be submitted to institutional investors by the underwriter with the price range as decided. Hence, the placement with investors happens almost overnight, and the pricing of the shares occurs within one or two days.
IPO Pricing Risk
With any type of initial public offering, companies run the risk of their stock being overpriced or under-priced when they set their IPO price. In case the shares are overvalued, this might discourage potential investors from being interested in case they aren’t certain that the company’s price and its actual value correspond. This discouraging reaction from the market can lead to a further price drop, lowering the value of the securities that have already been purchased.