5. Pricing of Securities

Since there is often significant uncertainty about the appropriate price at which to sell the shares to the IPO investors, the underwriters generally do not fix a specific issue price in advance. Therefore, so-called fixed-price offerings are comparatively rare in the case of IPOs.

 

Bookbuilding

Instead, the underwriter provides a specific price range for the offering and then invites interested investors to place bids to buy shares. More specifically, the investors indicate the number of shares that they are willing to buy at various price levels. The underwriter collects these bids and thereby builds the order book for the shares. This is why this process is called bookbuilding.

As the bids are entered in the order book, the underwriter learns about the demand for the shares as well as the price at which the issue can be placed. Bookbuilding is therefore a rather efficient price discovery method for the underwriter. 

The book is normally kept open for 5 days. During that time, investors can revise their bids. After that, the offer period is over and the order book is closed. Once the book is closed, the underwriter evaluates the bids and fixes the final issue price. 

 

Pricing

Often, the final issue price corresponds to the maximum price at which the full number of offered shares (plus greenshoe option) can be placed. That need not be the case, however. For example, in the case of Dropbox's IPO, the underwriters have originally indicated a price range of $16 - $18 per share. The bookbuilding revealed that there was tremendous demand for the firm's shares, so that the offer was oversubscribed by 21 times! The underwriters, together with Dropbox, therefore decided to set the issue price above the cap price of the original offer price range. Ultimately, the shares were sold at a price of $21 to the IPO investors on the primary market.

Fixing the issue price is a delicate task. On the one hand, the underwriter's responsibility is to raise as much money as possible for the issuing firm. On the other hand, even after the bookbuilding, there is still significant price uncertainty and this price uncertainty will not disappear until the shares trade normally on the stock exchange. To reward the investors on the primary market for taking this risk and for participating in the time consuming bookbuilding process, the underwriters therefore try to set the issue price below the expected trading price on the stock exchange, so that the IPO investors can expect to earn a positive return by participating in the IPO. This is the so-called underpricing. As we will discuss in more detail in the following section, the typical IPO is priced such that participating investors earn a return of approximately 15% on the first day of trading!

In the case of Dropbox, remember that the shares were sold at $21 to the IPO investors on the primary market. The next day, the shares started trading on the NASDAQ and closed the trading day at a price of $28.48. The lucky investors who bought shares in the IPO therefore earned a return of 36%—in a single day.

 

Final Prospectus and Share Allocation

Once the price as well as the number of shares to be sold has been fixed, the firm can file the final prospectus with the SEC. Only now is it allowed to accept legally binding subscriptions for the shares.

The next step for the underwriter therefore is to call up the interested investors and ask them to convert their indicative bids into binding subscriptions at the previously fixed issue price.

In this process, the underwriter and the issuer have great discretion. Cornelli and Golreich (2000) look how underwriters allocate shares to bidders in 39 international equity issues. They find that bidders who provide limit prices (that is, bidders who not only indicate the number of shares they want to buy, but also the price at which they want to buy) receive favorable allotments, possibly to reward them for the additional information they reveal to the underwriter. Possibly for the same reason, investors who revise their bids receive better allocations. Moreover, investors who regularly participate in IPOs receive favorable allocations, in particular in heavily oversubscribed issues. And so do domestic investors.