Book-building at work

Aarati Krishnan

Putting your money into a company’s IPO (Initial Public Offering) is now as easy as pie. Three clicks online and you’re done, without needing to fill out all those annoying little boxes in the application form. But what is NOT easy is wading through the tide of jargon that hits you in IPO season. Let’s decipher a few terms now whizzing around and put them in plain-speak.

Cut-off

First, the cut-off price. No, it’s nothing to do with buying a pair of jeans and hacking at it with blunt scissors to get a cooler-looking pair! Cut-off price is the price at which an IPO is finally priced. Or simply, the price at which you will finally be allotted shares in the company making the offer. Now, why call it cut-off? Because this is the price at which bids for the offer are literally cut off. Investors bidding below the cut-off price in a book-built offer will not get the shares they covet.

That brings us to how a book-built offer works. A book-built offer allows investors to put in bids at different prices for the shares of the company making the offer.

Much like in an auction, the company opens its “book” on a specific date (book-making is a term derived from horse racing) to invites bids for its shares.

Investors have a five-day window to decide on and bid for, the shares being offered. Just so we avoid the temptation to put in a ridiculously low sum, the company selling shares has the right to set a price band — the upper and lower limits — within which it will accept bids. Once the offer closes, the company will decide on the cut-off price or the winning price. If you tried to drive a hard bargain and bid below the cut-off price, your application will be rejected and you will receive a refund of all your money. If you put in a bid above the cut-off price, you will be allotted shares at the cut-off price.

Who wins?

How is this cut-off price decided? Does the highest bidder win? Or is it price chosen by the majority of investors?

Neither. The book-building process in India follows the Dutch auction method. In this kind of auction, the highest price at which the issuer gets bids for all the shares on offer, is the cut-off price.

Suppose Eat-away Fast Foods is offering 10,000 shares through a book-built IPO in the price band Rs 20-25. The IPO opens and at the end of five days, they find that: 5,000 bids are received at Rs 25, 2,500 bids at Rs 24 and another 2,500 bids at Rs 23. Rs 23 is the winning price, that can be set as the cut-off price. That is the highest price at which the issuer was able to get bids for all his shares. Once the price is “discovered” in this manner, the issuer can decide to set the cut-off price below this. But he cannot allot shares at any price higher than this level.

But wait, what if I have no clue how to value a company? How will I know what to bid? Well, that’s why retail investors alone have been given the extra option of bidding “at cut-off price” in every book-built IPO. When you choose the “Bid at cut-off” option on the application, you are basically telling the issuer: “I like this company but don’t know its price. So I’ll just sit back and let the other institutional guys fight over the price.”

Bidding at cut-off ensures that no matter what price is discovered for the IPO, you will be allotted shares at that price.

Sourced from: http://www.thehindubusinessline.com/