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What is Book Building?

Book building is a process of price discovery. It is a mechanism where, during the period for which the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer price is determined after the bid closing date.

Understanding Book Building

Book building has surpassed the 'fixed pricing' method, where the price is set prior to investor participation, to become the de facto mechanism by which companies price their IPOs. The process of price discovery involves generating and recording investor demand for shares before arriving at an issue price that will satisfy both the company offering the IPO and the market. It is highly recommended by all the major stock exchanges as the most efficient way to price securities.

IPO Pricing Risk

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.

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 invites investors, normally large scale buyers and fund managers, to submit bids on the number of shares that they are interested in buying and the prices that they would be willing to pay.
  3. The book is 'built' by listing and evaluating the aggregated demand for the issue from the submitted bids. The underwriter analyzes the information and uses a weighted average to arrive at the final price for the security, which is termed the 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.

Even if the information collected during the book building process suggests a particular price point is best, that does not guarantee a large number of actual purchases once the IPO is open to buyers. Further, it is not a requirement that the IPO be offered at that price suggested during the analysis.
eg:If Company XYZ opens ipo of 50000and the bid come as follows :

Price            Number of shares bidded
100                25050

110                30000

120                35000    

130                20000    

140                15000

150                15000   

Here the cumulative shares bidded from maximum price would be equal to 50000 at 130.(15000+15000+20000). In this case the cutoff price would be decided as Rs130 and all the price below that would not be allotted the shares. Also the price above the cutoff price would also be refunded. Here 10 and 20 rs would be refunded to those who applied for 140 and 150 rs respectively.

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