What is IPO book building?

by Manshu on November 12, 2010

in IPO/NFO

I got a comment the other day about how an IPO price band is fixed, and I thought I should do a post on the book building process, which is used to determine the final price for a lot of IPOs these days.

The crux of book building is that through people’s bids – the issuers find out the highest price at which they can sell their IPO.

Let me take an example. Suppose you own a company that sells Walkmans and want to do an IPO for your company. You decide to offer 3,000 shares at a price band of Rs. 20 – 24.

Since everyone wants a portable way to listen music, love the fact that they can rewind and listen to the same song over and over again – you receive bids from 5 bidders in the following manner:

Bid Quantity Bid Price Cumulative Quantity Subscription

500

24

500

16.67%

1,000

23

1,500

50.00%

1,500

22

3,000

100.00%

2,000

21

5,000

166.67%

2,500

20

7,500

250.00%

You obviously want to sell at the highest price of Rs. 24, but at that price you will be able to sell only 500 shares. So, you come down a rupee, but see that there are only a 1,000 bids at Rs. 23, so you will be able to sell 1,500 shares at that price only.

So, you come down a rupee again, and see that there are 1,500 bids at Rs. 22, which means that you’ve received 3,000 bids from people interested in buying your IPO stock at Rs. 22 or higher.

Rs. 22 then becomes  your cut – off price, and all bids above this price level are considered legal bids.

You will price your IPO at 22 or lower, but not at a higher price since you didn’t receive enough bids to be able to get your offering fully subscribed. This is known as the price discovery mechanism of the book building process, and the way most IPOs are priced these days.

In fact the example numbers I took above are very commonly found in prospectuses, and though in the real world, the numbers are much bigger, and complex this is the principle behind fixing the final price.

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