Book Building Process - How Are Prices Of Shares Decided In An IPO?
Companies all over the world use either fixed pricing or book building as a mechanism to price their shares. Over the period of time, the fixed price mechanism has become obsolete and book building has become the de-facto mechanism used in pricing shares while conducting an initial public offer (IPO). In this article, we will study how book building process works i.e. how are shares priced in an IPO:
What is Book Building ?
Book building is a price discovery mechanism that is used in the stock markets while pricing securities for the first time. When shares are being offered for sale in an IPO, it can either be done at a fixed price. However, if the company is not sure about the exact price at which to market its shares, it can decide a price range instead of an exact figure. This process of discovering the price by providing the investors with a price range and then asking them to bid on it is called the book building process. It is considered to be one of the most efficient mechanisms of pricing securities in the primary market. This is the preferred method which is recommended by all major stock exchanges and as a result is followed in all major developed countries in the world.
Book Building Process
The detailed process of book building is as follows:
Partial Book Building
Partial book building is another variation of the book building process. In this process, instead of inviting bids from the general population, investment bankers invite bids from certain leading institutions. Based on their bids, a weighted average of the prices is created and cut-off price is decided. This cut-off price is then offered to the retail investors as a fixed price. Therefore, the bidding only happens at an institutional level and not at a retail level.
This is also an efficient mechanism to discover prices. Also the cost and complications involved in conducting a partial book building are substantially low.
How is Book Building Better Than the Fixed Price Mechanism ?
First of all, the book building process brings flexibility to the pricing of IPO’s. Prior to the introduction of book building, a lot of IPO’s were either underpriced or overpriced. This created problems because if the issue was underpriced, the company was losing possible capital. On the other hand, if the issue was overpriced it would not be fully subscribed. In fact, if it was subscribed below a given percentage, the issue of securities had to be cancelled and the substantial costs incurred over the issue would simply have to be written off. With the introduction of book building process, such events no longer happen and the primary market functions more efficiently.