What is the Book-Building Process in an IPO?

If you are a stock market investor, you have probably heard of the Initial Public Offering (IPO), which is the procedure by which a business makes its shares available to the general public for the first time. However, have you ever thought about how the share price is determined? A business determines the price of its share by using a procedure known as the Book Building Process.

In this blog, we will describe the book-building process, its advantages and how it differs from the fixed price issues.

What is the Book Building Process in an IPO?

Businesses that want to go public and list their shares on the stock market use the book-building process as a price discovery technique. It is the most popular approach businesses use to set the price of the shares offered in an IPO, as it is the most effective and transparent way to determine the share price based on market demand. The Book Running Lead Manager is responsible for establishing the cut-off price by using a weighted average method. 

Example

Assume ABC Limited chooses to issue shares to the public to raise money. This is known as an initial public offering. To determine the issue price, they chose to use a book-building process and hired an underwriter. The corporation chose to issue 10,000 shares in total, with a price range of INR 100 to INR 110. Below is the tabular representation of investor bids:

The underwriter determines a weighted average price based on the above data, and we’ll assume that the corporation ultimately decides on a cut-off price of 105. Shares may be allotted to investors who bid on or above the cut-off price; investors who applied for the IPO with a bid below the cut-off price will not get any shares. Only Investors 2 and 3 are eligible to receive an allotment, whereas the IPO applications of Investors 1 and 4 will be rejected in the above scenario.  

How does the Book Building Process Work?

The steps which involve the book-building process are as follows-

1. Investment Banks – The first step is to select an investment bank as an underwriter for the Initial Public Offering (IPO). They assist the company in determining the issue size and establishing the share price range.

2. Price Band – The next stage would be to determine the minimum and maximum price of the shares offered in the IPO. 

3. Drafting Prospectus – A prospectus is prepared by the underwriter and contains details about the financials, business model, the objective of the issue, the shareholding pattern of the company, etc.

4. Approval of Prospectus – Once the prospectus is drafted, it will be sent to the Securities and Exchange Board of India. SEBI thoroughly analyzes and approves the document.

5. Bidding – Investors can apply for the IPO during the bidding period specified by the company, which typically lasts for 3 days.

6. Compiling Bids – Once all the bids are received, the lead manager compiles them and analyzes the quantity of shares applied by the investors at different price levels.

7. Cut-Off Price – Based on the bidding data, the lead managers determine the cut-off price. The investors who have applied for shares at or above the cut-off price may receive shares, but those who have applied below the cut-off price will not get any shares.

8. Allocation – Successful bidders will receive shares in their demat account.

Types of Book Building

There are generally two types of book-building process-

1. Accelerated Book Building – Accelerated Book-Building process is used when businesses want to raise funds quickly. The process is completed within one to two days because the underwriters approach institutional investors due to their ability to invest large amounts quickly.

2. Partial Book Building – In this process, the issuer reserves a limited number of shares for the Book-Building process, and the rest of the shares are offered at a fixed price.

Why do Companies Opt for the Book Building Process?

For several reasons listed below, the majority of Indian businesses choose to use a book-building process to determine the share price for their initial public offering.-

1. Market Price – The price of the IPO share is decided by the market participants, which generally reflects the actual market value based on the sentiments of the investors.

2. Increased Participation – Due to the market-driven pricing mechanism, investor confidence increases, which encourages more participation by the investors.

3. Fair Value – The shares may be overpriced or underpriced if a company chooses to issue at a predetermined price; however, the fair value of the issue will be determined if the company chooses to use the book-building process to determine the issue price. 

4. Regulations – The Securities and Exchange Board of India has issued certain guidelines for the book-building process, which ensures fairness and transparency in price discovery.

5. Allocation of Shares – Determining price through a book-building process ensures a more efficient allocation of shares. 

Advantages of Book Building in IPOs

The major advantages of the building process in IPO are as follows-

1. Flexibility – The book-building process allows the company to adjust the share price within the price range, which helps maximize investor participation. 

2. Reflects Demand – Book-building issues help companies determine the demand for shares among investors.

3. Maximizes Capital Raised– This method can help the company raise more capital as it determines the fair value of shares based on investor demand. 

Difference between Fixed Price Issue and Book Building

The major differences between fixed price and book-building issues are as follows-

Conclusion

Determining the share price of an IPO is an important task in the Initial Public Offering (IPO) process. The company may miss out on raising the maximum capital possible funding if the offer is underpriced. Conversely, investors may decide not to subscribe if the issue is overpriced. Therefore, before investing in any initial public offering (IPO), investors should determine whether the issue is reasonably priced and speak with their investment advisor. 

Frequently Asked Questions (FAQs)