Public issue of common shares is essentially carried out in two ways:
Fixed price issues are issues in which the issuer is allowed to price the shares as he wishes. The basis for the price is explained in an offer document through qualitative and quantitative statements. This offer document is filed with the stock exchanges and the registrar of companies.
Book-building is a process of price discovery used in public offers. The issuer sets a base price and a band within which the investor is allowed to bid for shares. Take the recent, Yes Bank IPO, the floor price was Rs 38 and the band was from Rs 38 to Rs 45.
The investor had to bid for a quantity of shares he wished to subscribe to within this band. The upper price of the band can be a maximum of 1.2 times the floor price.
Every public offer through the book-building process has a book running lead manager (BRLM), a merchant banker, who manages the issue.
Further, an order book, in which the investors can state the quantity of the stock they are willing to buy, at a price within the band, is built. Thus the term 'book-building.'
An issue through the book-building route remains open for a period of 3 to 7 days and can be extended by another three days if the issuer decides to revise the floor price and the band.
Cut-off price
Once the issue period is over and the book has been built, the BRLM along with the issuer arrives at a cut-off price. The cut-off price is the price discovered by the market. It is the price at which the shares are issued to the investors.
Investors bidding at a price below the cut-off price are ignored. So those investors who apply at a price higher than the cut-off price have a higher chance of getting the stock. So the question that arises is: How is the cut-off price fixed?
The cut-off price is arrived at by the method of Dutch auction. In a Dutch auction the price of an item is lowered, until it gets its first bid and then the item is sold at that price.
Let's say a company wants to issue one million shares. The floor price for one share of face value, Rs 10, is Rs 48 and the band is between Rs 48 and Rs 55.
At Rs 55, on the basis of the bids received, the investors are ready to buy 200,000 shares. So the cut-off price cannot be set at Rs 55 as only 200,000 shares will be sold. So as a next step, the price is lowered to Rs 54. At Rs 54, investors are ready to buy 400,000 shares. So if the cut-off price is set at Rs 54, 600,000 shares will be sold. This still leaves 400,000 shares to be sold.
The price is now lowered to Rs 53. At Rs53, investors are ready to buy 400,000 shares. Now if the cut-off price is set at Rs 53, all one million shares will be sold.
Investors who had applied for shares at Rs 55 and Rs 54 will also be issued shares at Rs 53. The extra money paid by these investors while applying will be returned to them.
Types of investors
There are three kinds of investors in a book-building issue. The retail individual investor (RII), the non-institutional investor (NII) and the Qualified Institutional Buyers (QIBs).
RII is an investor who applies for stocks for a value of not more than Rs 100,000. Any bid exceeding this amount is considered in the NII category. NIIs are commonly referred to as high net-worth individuals. On the other hand QIBs are institutional investors who posses the expertise and the financial muscle to invest in the securities market.
Mutual funds, financial institutions, scheduled commercial banks, insurance companies, provident funds, state industrial development corporations, et cetera fall under the definition of being a QIB.
Each of these categories is allocated a certain percentage of the total issue. The total allotment to the RII category has to be at least 35% of the total issue. RIIs also have an option of applying at the cut-off price. This option is not available to other classes of investors. NIIs are to be given at least 15% of the total issue.
And the QIBs are to be issued not more than 50% of the total issue. Allotment to RIIs and NIIs is made through a proportionate allotment system. The allotment to the QIBs is at the discretion of the BRLM.
Lately there have been some complaints by the QIBs of BRLMs resorting to favouritism while allocating shares. The Securities and Exchange Board of India (Sebi) is in the process of reviewing this mechanism.
Let's suppose, A Ltd, makes an offer for 200,000 shares. The issue is oversubscribed -- i.e. there is demand for more shares than the issuer plans to issue. Further, a minimum allotment of 100 shares is to be made for every investor.
The cut-off price has been decided and now the allotments are to be made. In the RII category, 1,500 applicants have applied for 100 shares each, i.e. there is a demand for 150,000 shares.
A Ltd plans to issue 35% of the total issue to this category, i.e. 70,000 shares. In the NII category, 200 applicants have applied for 500 shares each, i.e. 100,000 shares. A Ltd plans to issue 15% of the total issue to this category, i.e. 30,000 shares.
The cut-off price has already been decided, so adjusting the quantity remains the only way of reaching the equilibrium. Applying the proportionate allotment system each investor in the RII category will get 46.67 shares [(70,000/ 150,000) x 100)]. But the minimum allotment has to be 100 shares.
So through a lottery, 700 investors are chosen and allotted 100 shares each, making a total of 70,000 shares. In the NII category every investor will get 150 shares [(30,000/100,000) x 500)]. And that is how equilibrium is reached.
Green shoe option
In case the issue has been oversubscribed, as was the case with A Ltd, the company has to exercise a green shoe option to stabilize the post-listing price. When a particular issue is oversubscribed the appetite of investors for the stock has not been satisfied and once it gets listed they tend to pick up the stock from the secondary market.
Since the demand is greater than supply the prices tend to rise way beyond what the fundamentals of the stock would justify. So in order to stabilise the post-issue price of the stock, the issuer has to issue more shares in case of oversubscription.
These shares are taken from the pre-issue shareholders or promoters and are issued to the investors who have come in through the public offer on a prorata basis. The green shoe option can be a maximum of 15% of the public offer.
The author is a freelance writer.