When a company is considering going public, it typically hires an investment bank to advise it, and guide the company through the lengthy and costly IPO process. The investment bank, as the lead underwriter, commits to buying all the shares from the issuer at a certain price, assuming the risk of carrying them. Then the bank resells the shares to the market. With book building, the investment bank solicits a range of bids from its client base of institutional and large investors with capital. These preliminary bids give the bankers and the company’s management team a preview of the market’s appetite for the shares. Affirm, an online financial services company, is one example of a company that used book building as it went public on Jan. 13, 2021. The IPO was underwritten by Morgan Stanley, Goldman Sachs & Co. LLC and Allen & Company LLC, and had a preliminary offering range of $41 to $44 per share. However, after the roadshows, the final offer was priced at $49 per share. Affirm closed at $97.24 on the opening day of trading on the NASDAQ.
How Book Building Works
Roadshows
Book building begins with the bank holding a series of roadshows that help to promote the offering and create enthusiasm. Roadshows can include conference calls with multiple investors, in-person meetings, and the publication of materials on the internet about the issuer’s business and the offering. There are question-and-answer sessions at each roadshow, giving investors insight into the management strategy and future potential of the business headed for an IPO.
Indications of Interest
During the roadshows, the investment banker solicits “indications of interest” from prospective investors and clients. Indications of interest are non-binding bids for the offering, including the interest in price and quantity. The indications of interest are then built by the investment banker into an order book. The order book lists the number of shares and price offered by each potential investor. The investment banker uses the order book to recommend a final offering price to the issuer.
Allocations
Shortly before the new shares trade on an exchange, the investment banker allocates shares at the final offer price to its network of clients and investors. The banker allocates shares based on the indications of interest as well as its relationship with the investor.
Types of Book Building
In addition to the typical IPO, there are two specialized forms of book building.
Accelerated Book Building
Accelerated book building offers are used to sell a large block of shares or to raise capital quickly. The underwriting investment bank has to build the order book, set the final price, and allocate the shares within a short period of time, typically 48 hours or less. There are no roadshows.
Reverse Book Building
Reverse book building is used by an issuer to buy back shares. The underwriter solicits bids from existing shareholders and uses the order book to determine a final offering price for the shares.
Alternatives to Book Building
Book building is an integral part of the price discovery process for most initial public offerings. There are, however, other alternatives.
Auction
With an auction, a public bidding process is used to determine the offering price. Instead of roadshows and indications of interest from a select group of investors, all interested investors are given the opportunity to bid on shares prior to the IPO. Google took the auction route with its IPO in 2004.
Direct Listing
With direct listings, shares are offered directly to investors by the issuer on the first day of trading. In a direct listing, the initial share price is determined only by demand and supply of shares in the market. Underwriters are not involved in the sales process of direct listings. The cryptocurrency exchange Coinbase went public using a direct listing in April 2021.
Pros and Cons of Book Building
Pros Explained
Premarket price discovery: The roadshow and indications of interest give the issuer and the banker a clear picture of pricing and demand for the shares from professional and experienced investors with large amounts of capital to invest.Customized to issuer: Investment banks specialize in different sectors and industries, offering issuers expertise and credibility to their networks of investors.Lower risk to underwriter: The book building process reduces the risk of under subscription. When the offer is undersubscribed, the bank is responsible for any shares unsold at the offer price.
Cons Explained
Cost: The cost of auction and direct listing to the issuer are substantially lower, because shares are sold directly to investors and there are no broker fees.Potential for underpricing: The potential for underpricing is the main disadvantage to the issuer. Underpricing is the difference between the pre-market subscription price of the shares and the price on the opening day of trading. It’s considered “money left on the table” for the issuer. Underpricing is one of the reasons pre-IPO shares are attractive to investors.
