PROCESS AND PRICING IN IPO

Below are the steps a company must undertake to go public via an IPO process:

1. Select an Investment Bank

2. Due diligence and filings
3. Pricing
4. Stabilization
5. Transition

1. Select an Investment Bank: Choose an investment bank to advice on the IPO and
provide underwriting services.
Selection criteria:
 Reputation
 Quality of research
 Industry expertise
 Distribution
 Prior relationship with the bank

2. Due diligence and filings: Underwriting is the process through which an investment
bank (the underwriter) acts a broker between the issuing company and the investing
public to help the issuing company sell its initial set of shares. The following
underwriting arrangements are available to the issuing company:

 Firm Commitment: Under such an agreement, the underwriter purchases the whole offer
and resells the shares to the investing public. The firm commitment underwriting
arrangement guarantees the issuing company that a particular sum of money will be
raised.
 Best Efforts Agreement: Under such an agreement, the underwriter does not guarantee
the amount that they will raise for the issuing company. It only sells the securities on the
behalf of the company.
 Syndicate of Underwriters: Public offerings can be managed by one underwriter (sole
managed) or by multiple managers. When there are multiple managers, one investment
bank is selected as the lead or book-running manager. Under such an agreement, the lead
investment bank forms a syndicate of underwriters by forming strategic alliances with
other banks, each of which then sells a part of the IPO. Such an agreement arises when
the lead investment bank wants to diversify the risk of an IPO among multiple banks.

An underwriter must draft the following documents:

Engagement Letter: A letter of engagement typically includes:

1. Reimbursement clause: This clause mandates that the issuing company must cover the all
out-of-the-pocket expenses incurred by the underwriter, even if the IPO is withdrawn
during the due diligence stage, the registration stage, or the marketing stage.
2. Gross spread/underwriting discount: Gross spread is arrived at by subtracting the price at
which the underwriter purchases the issue from the price at which they sell the issue.
Letter of Intent: A letter of intent typically contains the following information:

1. The underwriter’s commitment to enter an underwriting agreement with the issuing

company
2. A commitment by the issuing company to provide the underwriter with all relevant
information and thus, fully co-operate in all due diligence efforts.
3. An agreement by the issuing company to provide the underwriter with a 15%
overallotment option.

The letter of intent does not mention the final offering price.

Underwriting Agreement: The letter of intent remains in effect till the pricing of the securities,
after which the Underwriting Agreement is executed. Thereafter, the underwriter is contractually
bound to purchase the issue from the company at a specific price.

Registration Statement: The registration statement consists of information regarding the IPO, the
financial statements of the company, the background of the management, insider holdings, any
legal problems faced by the company, and the ticker symbol to be used by the issuing company
once listed on the stock exchange. The SEC requires that the issuing company and its
underwriters file a registration statement after the details of the issue have been agreed upon. The
registration statement has two parts:

 The Prospectus – this is provided to every investor who buys the issued security
 Private filings –  this comprises information which is provided to the SEC for inspection
but is not necessarily made available to the public

The registration statement ensures that investors have adequate and reliable information about
the securities being important. The SEC then carries out due diligence to ensure that all the
required details have been disclosed correctly.

Red herring document: In the cooling off period, the underwriter creates an initial prospectus
which consists of the details of the issuing company, save the effective date and offer price. Once
the red herring document has been created, the issuing company and the underwriters market the
shares to public investors.

3. Pricing: Pricing of an Issue (IPO) Indian primary market ushered in an era of free pricing
in 1992. SEBI does not play any role in price fixation. The issuer in consultation with the
merchant banker on the basis of market demand decides the price. The offer document
contains full disclosures of the parameters which are taken in to account by merchant
Banker and the issuer for deciding the price. The parameters include EPS, PE multiple,
return on net worth and comparison of these parameters with peer group companies. On
the basis of pricing, an issue can be further classified into fixed price issue or book
building issue. In case of a fixed price issue the issuer at the outset decides the issue price
 and mentions it in the Offer Document, whereas in case on a book built issue the price of
an issue is discovered on the basis of demand received from the prospective investors at
various price levels.
The book building method is more efficient as it solves the "leakage" of value often seen with
fixed priced IPOs. Here the issuer sets a price range within which the investor is allowed to bid
for shares. The range is based on where comparable companies are trading and an estimate of the
value of the company that the market will bear. The investors then bid to purchase an agreed
number of shares for a price which they feel reflects fair value. By compiling a book of
investors, the issuer can ascertain what price range the shares should be valued at, based on the
demand of the people who are going to buy them, the investors. In this process supply and
demand are matched.

Globally, the book building method is favoured for its mutually beneficial nature: investors get
the shares at a fair price that typically has potential upside, and the issuing company receives fair
compensation.

However regionally it is likely to take some time to adapt to this method. Issuers clearly have a
vested interest in moving to an approach that is more likely to lead to a better price for their
companies. This upsets some investors in the short term, who are used to making a lot of money
from these fixed price IPOs.

In the longer-term, however, efficient pricing should be seen as a sign of the growing maturity of
the capital markets in the region.

Book Building Process:

Book building is a process of price discovery. The issuer discloses a price band or floor price
before opening of the issue of the securities offered. On the basis of the demands received at
various price levels within the price band specified by the issuer, Book Running Lead Manager
(BRLM) in close consultation with the issuer arrives at a price at which the security offered by
the issuer, can be issued. The price band is a band of price within which investors can bid. The
spread between the floor and the cap of the price band cannot be more than 20 percent. The price
band can be revised. If revised, the bidding period is extended for a further period of three days,
subject to the total bidding period not exceeding thirteen days.
A floor price or price band within which the bids can move is disclosed at least two working
days before opening of the issue in case of an IPO and atleast one day before opening of the
issue in case of an FPO. The applicants bid for the shares quoting the price and the quantity that
they would like to bid at. After the bidding process is complete, the ‘cut-off’ price is arrived at
based on the demand of securities. The basis of allotment is then finalized and allotment/refund
is undertaken. The final prospectus with all the details including the final issue price and the
issue size is filed with Registrar of Companies (ROC), thus completing the issue process. Only
the retail investors have the option of bidding at ‘cut-off’. Cut-off” option is available for only
retail individual investors i.e. investors who are applying for securities worth up to ` 1,00,000/-
only. Such investors are required to tick the cut-off option which indicates their willingness to
subscribe to shares at any price discovered within the price band. Unlike price bids (where a
specific price is indicated) which can be invalid, if price indicated by applicant is lower than the
price discovered, the cut-off bids always remain valid for the purpose of allotment.

The investor can change or revise the quantity or price in the bid using the form for
changing/revising the bid that is available along with the application form. However, the entire
process of changing or revising the bids is to be completed within the date of closure of the issue.
The investor can also cancel the bid any time before the finalization of the basis of allotment by
approaching/ writing/ making an application to the registrar of the issue. The syndicate member
returns the counterfoil with the signature, date and stamp of the syndicate member. Investor can
retain this as a sufficient proof that the bids have been accepted by the trading / syndicate
member for uploading on the terminal.
Difference between Book Building Issue and Fixed Price Issue

Features Fixed price process Book building process

Pricing Price at which the securities are Price at which securities will be offered/
offered/ allotted is known in allotted is not known in advance to the
advance to the investor. investor. Only an indicative price range
is known.
Demand Demand for the securities offered is Demand for the securities offered can
known only after the closure of the be known everyday as the book is built.
issue.
Payment Payment if made at the time of Payment only after allocation.
subscription wherein refund is given
after allocation.

UNDERPRICING AND OVERPRICING OF IPO

UNDERPRICING

The pricing of an IPO at less then its market value is referred to as “underpricing”. In other
words. It is the difference between the offer price of the first time. Historically, IPO’s have
always been “underpriced” underpriced helps to generate additional interest in the stock when it
first becomes publicly traded. This might results in significant gains for investors who have been
allocated shares at the offering prices. However under pricing also results in loss of significant
amount of capital that could have been raised had the shares been offered at the higher price.

OVERPRICING

The pricing of an IPO at more than its market value is referred to as “overpricing” even over
pricing of an shares is not as as healthy option. If the stock is offered at a higher price than what
the market is willing to pay. Then it is likely to become difficult for the underwriter to full fill
there commitment to sell shares. Furthermore, even if the underwriter are successful in selling all
the issued shares and the stock falls in value on the first day itself of trading. Then it is likely to
lose its marketability and hence, even more of it’s value.
4. Stabilization: After the issue has been brought to the market, the underwriter has to
provide analyst recommendations, after-market stabilization and create a market for
the stock issued. The underwriter carries out after-market stabilization in the event of
order imbalances by purchasing shares at the offering price or below it. Stabilization
activities can only be carried out for a short period of time. However, during this period
of time, the underwriter has the freedom to trade and influence the price of the issue as
prohibitions against price manipulation are suspended.

5. Transition to Market Competition: The final stage of the IPO process, the transition to
market competition, starts 25 days after the initial public offering, once the “quiet period”
mandated by the securities end. During this period, investors transition from relying on
the mandated disclosures and prospectus to relying on the market forces for information
regarding their shares. After the 25-day period lapses, underwriters can provide estimates
regarding the earning and valuation of the issuing company. Thus, the underwriter
assumes the roles of advisor and evaluator once the issue has been made.