To understand book building, we need to know the various sources of funds for any business. A primary source of funds for any business is borrowing money from banks and financial institutions. Private placement is another form of raising funds. Another common source of funds utilized a lot lately by start-ups is going public. As of 1st December 2021, a total of 72 start-ups have raised funds in the Indian capital market. Resultantly, India ranks 12th in the global market for companies raising funds through IPO’s.
These IPO’s are obviously made by companies/organizations. But the moot question is who helps and facilitates the entire process for these organizations. The answer is Investment banks. These investment banks or bankers advise and take upon them to conduct the entire process on behalf of these organizations. And this is to make/convert their private company to a public company with a view to arranging funds from the public for the business. It begins with regulatory compliances that are seeking permissions from the regulators, for example, The Securities Exchange Commission (SEC) in the US. After seeking permissions, the most important part is valuing the company, deciding on the IPO price, etc. One important function of an investment bank is book building. Through this article, let us try understanding the meaning and process of book building for an IPO.
Meaning and Purpose
Let us take an example. Suppose Company X wants to issue an IPO to raise funds for various reasons, mainly because they are planning an expansion. Before going public, the investment bank in charge of company X’s IPO will conduct a mock IPO to understand the demand for the shares of Company X. This process we call or name as the book-building process. Price discovery is one of the primary goals of the process. In this process, the book runner (investment bank) invites applications, primarily from institutional investors, financial institutions, and high-net-worth individuals. The book runner will ask the investors to submit their bid price, i.e., the price at which they would buy the share and the likely quantum of the shares they would bid for.
To sum up, the purpose of book building is to understand the factors and intentions of the market in setting a price for the company. Many security exchanges of the world consider book building as an effective method.
Process of Book Building
Appointing an Investment Bank
The issuing company will select a lead investment bank that is responsible for due diligence, deciding upon the price band, i.e., the minimum and maximum price for bids, and tracking and deciding the price for the issue. The investment bank also helps a firm in deciding the capacity/quantum of the IPO.
Inviting investors to bid their prices for the shares. These bids have to be in the price range specified by the investment banks. The main participants in the bidding process include High net worth individuals, financial institutions, investment institutions, PF and Pension Funds, Mutual Funds and banks, etc. The investment bank extends its network and advertises rigorously to receive bids from a large number of investors. They do make investor presentations and roadshows also to attract bids. In a closed market, these details remain confidential to the investment bank and issuing company. Whereas in the open market, the investors bidding price can see the bids of other investors.
Setting the Price
Once the investment bank receives all the bids, it works out a weighted average price of all the bids to determine the final price of the IPO. This weighted average price becomes the cut-off price for the purpose of bid and allocation. A hot issue is an issue that is able to attract a large number of investors, and that sees a good price-performance potential for the investors. Such issues often witness a cut-off price equal to the ceiling price (upper limit of the price band). The price remains confidential, known only to the book runner and the issuing company.
Stock exchanges all over the world say it is the duty of the book runners to publicize the bids, a measure to increase transparency.
Settling the Transaction
After the cut-off price, a settlement process is conducted. For instance, an investor who bought the shares at a bid price lower than the cut-off price has to pay the difference amount between the cut-off price and the price paid by him to settle the transaction. Similarly, an investor with a higher bid price gets a refund of the difference amount.
Why do we Use Book Building?
Book building is a process that helps the issuing company sell at a price that captures its potential well. Earlier, before the introduction of book building, many companies faced an issue of under-pricing, i.e., received less capital or overpriced shares that were not fully subscribed. Book building helps issuing companies avoid these barriers and secure funds as required.
What do you Mean by Reverse Book Building?
Reverse book building happens when a company wants to buy back its shares from the existing investors/public. The shareholders are asked to bid prices above the floor price. These prices are then used to determine the buyback price of the shares. Exactly as we do in a book-building process for issuance of shares. The company has to appoint a leading book runner for this process.