What is Book Building - The Book Building Process
Whenever a company wants to sell its shares in the open market, it faces a very important question. The question is that what should the price of the shares being sold be? Over the years, investment bankers have tried multiple ways to find out the fair price at which the shares should be sold. Many processes have evolved over the ages. However, the book-building has proved to be the most sophisticated. Almost every public issue nowadays is launched using the book-building process. Many leading stock exchanges of the world mandate the use of book building.
In this article, we will have a closer look at what the book-building process is and what are some of the advantages that the process has to offer:
What is Book Building?
As mentioned above, book building is a price discovery process that is used when shares are being offered for sale for the first time. The term "book building" is derived from the fact that investment bankers used to record all the price bids received in a "book." Hence, book building refers to a process wherein various quotes and expressions of interest are received by the investment bankers. The eagerness of the prospective investors and their willingness to pay the highest price are measured in order to derive the correct selling price.
Steps Followed in Book Building
The first step in the book-building process involves the creation of a draft red herring prospectus. Basic financial and operational details about the company are shared with the investing community. This helps them run their own discounted cash flow models and come up with a fundamental value for the firm.
The second step of the book-building process happens during the roadshows, i.e. when investors meet the investment bankers. The investment bankers solicit bids from them at various price levels. Often times, the task of soliciting bids is done by multiple investment banks which may be involved in the issue process. The purpose of this exercise is to create a demand schedule which can then be plotted on a graph sheet and then converted into a demand curve. During the bidding process, the investment bankers do not provide one single price. Instead, they provide a price range wherein a floor price and a ceiling price are mentioned. Investors can place their bids at any price, which falls in the range.
After receiving all the bids, an aggregate of all the prices is done, and a cut off price is reached. This cut-off price is the price at which shares are issued. In most successful IPOs, most bids are received for the ceiling price. Hence, it is very common for the ceiling price to be the cut-off price as well. Also, in order to maintain transparency in the process, investment bankers are required to publicly disclose the details of the bids received.
During the last stage, allotment of shares is done at the cut-off price. Hence, if an investor has bid at a higher price, their money is refunded. If an investor has bid low, then the money is asked from them. Most public issues managed by leading investment banks are oversubscribed several times. This means that investors do not receive all the shares that they had bid for. Instead, the shares are pro-rated. This means that, for example, if they had bid for 100 shares, they will receive only 50.
Types of Book Building
Over the years, book building has evolved into several subtypes. Some of them have been mentioned below:
In some cases, book building bids are not invited from the retail investors. Instead, investment bankers only ask for bids from a selected group of investors. The demand projected by these investors is used to determine the cut-off price at which the share will finally be sold. The retail investor and other small investors simply have to take the cut-off price derived as a fixed price. They can take it or leave it. There is no room for bidding or bargaining. This method is called a partial book building.
There is another method of book building, which is often used to raise funds quickly. It is called an accelerated book building. This method is used when funds are required overnight, and there is no scope for marketing. Here instead, of a public issue, bids are sought from a select group of investors. The shares are offered to those investors based on their bids. There is little or no regulatory oversight for this process. This is the reason that it is often used to raise money in lieu of debt.
The book-building process minimizes the chances of failure of the public issue. The company does not blindly offer its shares at a price on which they cant be sold. It virtually guarantees a successful public issue. However, companies have very little control over the process, and it becomes difficult for them to budget the amount of money that they will receive at the end of the process. Another problem is that the services of investment bankers are extensively required during the book-building process. As a result, the fees, as well as charges involved, are also high. This makes book building the most expensive price discovery method.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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