Understanding Book Building in IPO Pricing

What Is Book Building?

Book building is how underwriters decide the price for an initial public offering (IPO). An underwriter, usually an investment bank, invites institutional investors to bid on shares and prices.

The process is designed to discover the optimal price through investor demand. The standard for pricing IPOs, book building, is preferred by major exchanges over fixed pricing methods. The process begins with the issuing company hiring an underwriter to determine the price range of the security and draft a prospectus. The investment bank then solicits large investors and fund managers to bid on the shares and prices. This builds the book that the underwriter uses to weigh the averages of bids and set the final price. Finally, the shares are allocated to the accepted bidders.

Why Is Book Building Important in IPOs?

Book building is the standard for pricing IPOs and is recommended by major stock exchanges. Price discovery generates and records investor demand to determine the issue price. It is highly recommended by all the major stock exchanges as the most efficient way to price securities.

The book building process comprises these steps:

1. The issuing company hires an investment bank to act as an underwriter, who is tasked with determining the price range the security can be sold for and drafting a prospectus to send out to the institutional investing community.
2. The investment bank asks large investors and fund managers to bid on shares and prices.
3. The book is ‘built’ by listing and evaluating demand from submitted bids. The underwriter uses a weighted average of bids to set the final cutoff price.
4. The underwriter has to, for the sake of transparency, publicize the details of all the bids that were submitted.
5. Shares are allocated to the accepted bidders.

Suggested prices from book building don’t guarantee many purchases once the IPO starts. It’s not required to offer the IPO at the suggested price.

What You Need to Know About Accelerated Book Building

An accelerated book-build is often used when a company is in immediate need of financing, in which case, debt financing is out of the question. This can be the case when a firm is looking to make an offer to acquire another firm. If a company can’t get extra financing due to high debt, it can use accelerated book-building for quick equity market funds.

With an accelerated book build, the offer period is open for only one or two days, and with little to no marketing. In other words, the time between pricing and issuance is 48 hours or less. A book build that is accelerated is frequently implemented overnight, with the issuing company contacting a number of investment banks that can serve as underwriters on the evening prior to the intended placement. The issuer solicits bids in an auction-type process and awards the underwriting contract to the bank that commits to the highest backstop price. The underwriter submits the proposal with the price range to institutional investors. In effect, placement with investors happens overnight, with the security pricing occurring most often within 24 to 48 hours.

Understanding the Risks in IPO Pricing

With any IPO, there is a risk of the stock being overpriced or undervalued when the initial price is set. If it is overpriced, it may discourage investor interest if they are not certain that the company’s price corresponds with its actual value. This reaction within the marketplace can cause the price to fall further, lowering the value of shares that have already been secured.

In cases where a stock is undervalued, it is considered to be a missed opportunity on the part of the issuing company, as it could have generated more funds than were acquired as part of the IPO.