Category: Management Notes

Companies all over the world use either fixed pricing or book building as a mechanism to price their shares. Over the period of time, the fixed price mechanism has become obsolete and book building has become the de-facto mechanism used in pricing shares while conducting an initial public offer (IPO). In this article, we will study how book building process works i.e. how are shares priced in an IPO:

Book building is a price discovery mechanism that is used in the stock markets while pricing securities for the first time. When shares are being offered for sale in an IPO, it can either be done at a fixed price. However, if the company is not sure about the exact price at which to market its shares, it can decide a price range instead of an exact figure. This process of discovering the price by providing the investors with a price range and then asking them to bid on it is called the book building process. It is considered to be one of the most efficient mechanisms of pricing securities in the primary market. This is the preferred method which is recommended by all major stock exchanges and as a result is followed in all major developed countries in the world.

Book Building Process

The detailed process of book building is as follows:

1. Appointment of Investment Banker: The first step starts with appointing the lead investment banker. The lead investment banker conducts due diligence. They propose the size of the capital issue that must be conducted by the company. Then they also propose a price band for the shares to be sold. If the management agrees with the propositions of the investment banker, the prospectus is issued with the price range as suggested by the investment banker. The lower end of the price range is known as the floor price whereas the higher end is known as the ceiling price. The final price at which securities are indeed offered for sale after the entire book building process is called the cut-off price.
2. Collecting Bids: Investors in the market are requested to bid to buy the shares. They are requested to bid the number of shares that they are willing to buy at varying price levels. These bids along with the application money are supposed to be submitted to the investment bankers. It must be noted that it is not a single investment banker who is engaged in the collection of bids. Rather, the lead investment banker can appoint sub-agents to tap into their network especially for receiving the bids from a larger group of individuals.
3. Price Discovery: Once all the bids have been aggregated by the lead investment banker, they begin the process of price discovery. The final price chosen in simply the weighted average of all the bids that have been received by the investment banker. This price is declared as the cut-off price. For any issue which has received substantial publicity and which is being anticipated by the public, the ceiling price is usually the cut-off price.
4. Publicizing: In the interest of transparency, stock exchanges all over the world require that companies make public the details of the bids that were received by them. It is the lead investment banker’s duty to run advertisements containing the details of the bids received for the purchase of shares for a given period of time (let’s say a week). The regulators in many markets are also entitled to physically verify the bid applications if they wish to.
5. Settlement: Lastly, the application amount received from the various bidders has to be adjusted and shares have to be allotted. For instance, if a bidder has bid a lower price than the cut-off price then a call letter has to be sent asking for the balance money to be paid. On the other hand, if a bidder has bid a higher price than the cut-off, a refund cheque needs to be processed for them. The settlement process ensures that only the cut-off amount is collected from the investors in lieu of the shares sold to them.

Partial Book Building

Partial book building is another variation of the book building process. In this process, instead of inviting bids from the general population, investment bankers invite bids from certain leading institutions. Based on their bids, a weighted average of the prices is created and cut-off price is decided. This cut-off price is then offered to the retail investors as a fixed price. Therefore, the bidding only happens at an institutional level and not at a retail level.

This is also an efficient mechanism to discover prices. Also the cost and complications involved in conducting a partial book building are substantially low.

First of all, the book building process brings flexibility to the pricing of IPO’s. Prior to the introduction of book building, a lot of IPO’s were either underpriced or overpriced. This created problems because if the issue was underpriced, the company was losing possible capital. On the other hand, if the issue was overpriced it would not be fully subscribed. In fact, if it was subscribed below a given percentage, the issue of securities had to be cancelled and the substantial costs incurred over the issue would simply have to be written off. With the introduction of book building process, such events no longer happen and the primary market functions more efficiently.

Stock Exchange (also called Stock Market or Share Market) is one important constituent of capital market. Stock Exchange is an organized market for the purchase and sale of industrial and financial security. It is convenient place where trading in securities is conducted in systematic manner i.e. as per certain rules and regulations.

It performs various functions and offers useful services to investors and borrowing companies. It is an investment intermediary and facilitates economic and industrial development of a country.

Stock exchange is an organized market for buying and selling corporate and other securities. Here, securities are purchased and sold out as per certain well-defined rules and regulations. It provides a convenient and secured mechanism or platform for transactions in different securities. Such securities include shares and debentures issued by public companies which are duly listed at the stock exchange, and bonds and debentures issued by government, public corporations and municipal and port trust bodies.

Stock exchanges are indispensable for the smooth and orderly functioning of corporate sector in a free market economy. A stock exchange need not be treated as a place for speculation or a gambling den. It should act as a place for safe and profitable investment, for this, effective control on the working of stock exchange is necessary. This will avoid misuse of this platform for excessive speculation, scams and other undesirable and anti-social activities.

London stock exchange (LSE) is the oldest stock exchange in the world. While Bombay stock exchange (BSE) is the oldest in India. Similar Stock exchanges exist and operate in large majority of countries of the world.

Characteristics or features of stock exchange are:

1. Market for securities: Stock exchange is a market, where securities of corporate bodies, government and semi-government bodies are bought and sold.
2. Deals in second hand securities: It deals with shares, debentures bonds and such securities already issued by the companies. In short it deals with existing or second hand securities and hence it is called secondary market.
3. Regulates trade in securities: Stock exchange does not buy or sell any securities on its own account. It merely provides the necessary infrastructure and facilities for trade in securities to its members and brokers who trade in securities. It regulates the trade activities so as to ensure free and fair trade
4. Allows dealings only in listed securities: In fact, stock exchanges maintain an official list of securities that could be purchased and sold on its floor. Securities which do not figure in the official list of stock exchange are called unlisted securities. Such unlisted securities cannot be traded in the stock exchange.
5. Transactions effected only through members: All the transactions in securities at the stock exchange are affected only through its authorised brokers and members. Outsiders or direct investors are not allowed to enter in the trading circles of the stock exchange. Investors have to buy or sell the securities at the stock exchange through the authorised brokers only.
6. Association of persons: A stock exchange is an association of persons or body of individuals which may be registered or unregistered.
7. Recognition from Central Government: Stock exchange is an organised market. It requires recognition from the Central Government.
8. Working as per rules: Buying and selling transactions in securities at the stock exchange are governed by the rules and regulations of stock exchange as well as SEBI Guidelines. No deviation from the rules and guidelines is allowed in any case.
9. Specific location: Stock exchange is a particular market place where authorised brokers come together daily (i.e. on working days) on the floor of market called trading circles and conduct trading activities. The prices of different securities traded are shown on electronic boards. After the working hours market is closed. All the working of stock exchanges is conducted and controlled through computers and electronic system.
10. Financial Barometers: Stock exchanges are the financial barometers and development indicators of national economy of the country. Industrial growth and stability is reflected in the index of stock exchange.

The earliest stock exchange was set up in Amsterdam in 1602 and it was involved in buying and selling of shares for Dutch East India Company. Prior to this, brokers existed in France dealing with government securities. It must be noted that the first real stock exchange started in Philadelphia in the United States during the late 18th century. Later, the New York Stock Exchange became popular and Wall Street became the hotspot of brokerage activities. Earlier stockbrokers were largely unorganised, but later most of them joined hands to form institutions and organisations.

Security Trading in India goes back to the 18th century when East India Company began trading in loan securities.

Derivatives market have been functioning in India in some form or the other for a long time. Corporate shares with the stock of Bank and Cotton presses started being traded in the 1830s in Mumbai with Bombay Cotton Trade Association being the first to start future trading in 1875 in the arena of commodities trading and by the early 1900s, India had one of the world’s largest futures industry. Going back to 1850s the roots of stock exchanges in India sprouting when 22 stockbrokers began trading opposite the Town Hall of Bombay under a banyan tree. The tree is still present in the area and is known as Horniman Circle.

This trading continued till a shift to banyan trees at the Meadows Street Junction, which is now known as Mahatma Gandhi Road, a decade later. The shift was an ongoing one and number of brokers gradually increased finally settling in 1874 at what is known as Dalal Street. The group of 318 people came together to form “Native Shares and Stock Brokers Association” and the membership fee was Re 1. This association is now known as Bombay Stock Exchange (BSE) and in 1965 it was given permanent recognition by the Government of India under the Securities Contracts (Regulation) Act (SCRA), 1956. BSE is also the oldest stock exchange in Asia and it is been 144 years since it has been formed. Following its formation, Ahmedabad stock exchange came into operation in 1894 trading in shares of textile mills. Another development in the history of stock exchanges began with the Calcutta stock exchange opening up in 1908 and began trading shares of plantations and jute mills. It was followed by Madras Stock Exchange starting in 1920.

Post-independence Era and Reforms in the market

There were a series of reforms in the stock market between 1993 and 1996 which further lead to the development of exchange-traded equity derivatives markets in India.

There was a certain element of the trading system called “Badla” involving some elements of forwards trading which had been in existence for decades. This practice led to the growth of undesirable market practices and to check this development it was prohibited off and on till it was banned in 2001. In the 1980s stockbroking services were restricted only to the wealthy class who could afford them. With the spread of the Internet, stockbroking became accessible.

In the 1990s stock market witnessed a steady increase in stock market crises. An aspect of these crises was market manipulation on the secondary market. Following are the incidents which prompted the development of the stock market:

1. 1992: Harshad Mehta: The first “stock market scam” was one which involved both the GOI bond and equity markets in India. Thereafter, manipulation was based on inefficiencies in the settlement system in GOI bond market transactions. Inflation came about in the equity markets and the market index went up by 143% between September 1991 and April 1992 and the amount involved in the crises was Rs 54 billion.
2. 1994: MS Shoes: Here the dominant shareholder of the firm, took large leveraged positions through brokers at both Delhi and Bombay stock exchanges, to manipulate share prices prior to the rights issue. After the share prices crashed, broker defaulted and BSE shut down for three days in a consequence.
3. 1995: Sesa Goa: Another episode of market crises for the BSE, was the case of price manipulation of the shares of Sesa Goa. This was perpetrated by two brokers, who later failed on their margin payments on leveraged positions in the shares and the exposure was around 4.5 million.
4. 1995: Bad deliveries of physical certificates: When anonymous trading and the nationwide settlement became the norm by the end of 1995, there was an increased incidence of fraudulent shares being delivered into the market. It has been the expected cost of encountering fake certificates in equity settlement in India at the time was as high as 1%.
5. 1997: CRB. C.R. Bhansali created a group of companies, called the CRB group, which was a conglomerate of finance and non-finance companies. Market manipulation was an important focus of group activities. The non-finance companies routed funds to finance companies for price manipulations. The non-finance companies were tasked with sourcing funds from external sources, using manipulated performance numbers. The CRB episode was particularly important in the way it exposed extreme failures of supervision on part of RBI and SEBI. The amount involved in the episode was Rs 7 billion.
6. 1998: BPL, Videocon and Sterlite: This is an episode of market manipulation involving the broker that engineered the stock market bubble of 1992, Harshad Mehta. He seems to have worked on manipulating the share prices of these three companies, in collusion.
7. 2001: Ketan Parekh. This was triggered by a fall in the prices of IT stocks globally. Ketan Parekh was seen to be a leader of the episode, with leveraged positions onset of stocks called the “K10 stocks”. There are allegations of fraud in this crisis with respect to an illegal “Badla” market at the Calcutta Stock Exchange and banking fraud.

The above instances have had a disruptive effect on the market that is(i) pricing efficiency (ii) intermediation between households investing in shares and firms financing projects by issuing shares which were resolved by reform measures by the government.

In the post-independence era, the BSE dominated the volume of trading. However, the low level of transparency and undependable clearing and settlement systems, apart from other macro factors, increased the need for a financial market regulator, and the SEBI was born in 1988 as a non-statutory body. Later it was made a statutory body in 1992.

Thereafter, in 1952 cash settlement and options trading were prohibited by the government and derivatives trading shifted to informal forwards market. At present, the government allows for markets based pricing mechanism and shows less scepticism towards derivatives trading. The prohibition on futures trading of many commodities was lifted starting in the early 2000s and national electronic exchanges were created. In the 1980s stockbroking services were used only by a wealthy class who could afford them. With the rise of the Internet, stockbroking services became accessible to even the common man. Major organisations became involved in stockbroking activities. 

Although in the wake of Harshad Mehta scam in 1992, there was a pressing need for another stock exchange large enough to compete with BSE and bring transparency to the stock market. It leads to the development of the National Stock Exchange (NSE). It was incorporated in 1992, became recognised as a stock exchange in 1993, and trading began on it in 1994. It was the first stock exchange on which trading was conducted electronically. In response to this competition, BSE also introduced an electronic trading system known as BSE Online Trading (BOLT) in 1995.

Thereafter, BSE launched its own sensitivity index, the Sensex, known at present as the S&P BSE Sensex, in 1986 with 1978-79 as the base year. This is an index of 30 companies and is a benchmark stock index, measuring the overall performance of the exchange. Equity derivatives were introduced by the exchange in 2000. Index options launched in June 2001, stock options in July 2001, and stock futures in November 2001. India’s first free-float index, BSE Teck, was launched in July 2001.

Its competitor, NSE launched its benchmark exchange, the CNX Nifty, now known as Nifty 50, in 1996. It comprises of 50 stocks and functions as a performance measure of the exchange. In terms of electronic screen-based trading and derivatives, it has left behind its competitor BSE by introducing first of its kind products and services.

Stock exchanges at present

After incorporation of BSE and NSE, 23 stock exchanges were added not including the BSE. At present, there are 23 approved stock exchanges in India out of which 6 are functional:-

1. BSE Ltd
2. Calcutta Stock Exchange
3. India International Exchange (India INX)
4. Metropolitan Stock Exchange
5. NSE 
6. NSE IFSC Ltd

Thus, from the times when buyers and sellers had to assemble at stock exchanges for trading till the present times when the dawn of IT has made the operations at stock exchanges electronic hence making stock markets paperless. Trading facilities can be accessed from home or office on phone or Internet. Therefore, with new products and services, rampant growth in stock trading can be foreseen.

Initial public offering is the process by which a private company can go public by sale of its stocks to general public. It could be a new, young company or an old company which decides to be listed on an exchange and hence goes public.

Companies can raise equity capital with the help of an IPO by issuing new shares to the public or the existing shareholders can sell their shares to the public without raising any fresh capital.

A company offering its shares to the public is not obliged to repay the capital to public investors.

The company which offers its shares, known as an ‘issuer’, does so with the help of investment banks. After IPO, the company’s shares are traded in an open market. Those shares can be further sold by investors through secondary market trading.

An IPO (initial public offering) is referred to a flotation, which an issuer or a company proposes to the public in the form of ordinary stock or shares. It is defined as the first sale of stock by a private company to the public. They are generally offered by new and medium-sized firms that are looking for funds to grow and expand their business.

 It is also referred to as “public offering”

 Basics of private and public:

• Private
• Public

A privately held company has fewer shareholders and its owners don’t have to disclose much information about the company. Most small businesses are privately held, with no exceptions that large companies can be private too, like Domino’s Pizza and Hallmark Cards being privately held. Shares of private companies can be reached through the owners only and that also at their discretion. On the other hand, public companies have sold at least a portion of their business to the public and thereby trade on a stock exchange. This is why doing an IPO is referred to going public.

The main reason for going public is to raise the good amount of cash through the various financial avenues that are offered. Besides, the other factors include:

• Public companies usually get better rates when they issue debt due to increased scrutiny.
• As long as there is market demand, a public company can always issue more stock.
• Trading in the open markets means liquidity.
• Being Public makes it possible to implement things like employee stock ownership plans, which help to attract top talent of the industry.

Factors to be considered before applying for an IPO:

There are certain factors which need to be taken into consideration before applying for Initial Public Offerings in India:

• The historical record of the firm providing the Initial Public Offerings
• Promoters, their reliability, and past records
• Products offered by the firm and their potential going forward
• Whether the firm has entered into a collaboration with the technological firm
• Project value and various techniques of sponsoring the plan
• Productivity estimates of the project
• Risk aspects engaged in the execution of the plan

General Terms involved in IPO:

Primary market: It is the market in which investors have the first opportunity to buy a newly issued security as in an IPO.

Prospectus: A formal legal document describing the details of the company is created for a proposed IPO, also making the investors aware of the risks of an investment. It is also known as the offer document.

Book building: It is the process by which an attempt is made to determine the price at which the securities are to be offered based on the demand from investors.

Over-Subscription: A situation in which the demand for shares offered in an IPO exceeds the number of shares issued.

Green shoe option: It is referred to as an over-allotment option. It is a provision contained in an underwriting agreement whereby the underwriter gets the right to sell investors more shares than originally planned by the issuer in case the demand for a security issue proves higher than expected.

Price band: Price band refers to the band within which the investors can bid. The spread between the floor and the cap of the price band is not more than 20% i.e. the cap should not be more than 120% of the floor price. This is decided by the company and its merchant bankers. There is no cap or regulatory approval needed for determining the price of an IPO.

Listing: Shares offered in IPOs are required to be listed on stock exchanges for the purpose of trading. Listing means that the shares have been listed on the stock exchange and are available for trading in the secondary market.

Flipping: Flipping is reselling a hot IPO stock in the first few days to earn a quick profit. The reason behind this is that companies want long-term investors who hold their stock, not traders.

1. Growth in Financial Intermediation:

The Indian capital market has grown due to innovation of the mechanism of indirect financing.

This innovation has enhanced the efficiency of flow of funds from ultimate savers to ultimate users through newly established financial intermediaries like UTI, LIC and GIC. The LIC has been mobilising the savings of households to build a ‘life fund’.

It has been deploying a part of ‘life fund’ to purchase the shares and debentures of the companies. Until 1991 UTI was amongst the top ten shareholders in one out of every three companies listed in the Stock Exchange in which it had a shareholding. Likewise, UTI has been mobilising savings of households through the sale of ‘units’ to invest in securities of ‘blue-chip’ companies.

In short, financial intermediaries like LIC, UTI and GIC have activated the growth process of Indian capital market. It is evident from the rising intermediation ratio. The intermediation ratio is a ratio of the volume of financial instruments issued by the financial institutions, i.e., secondary securities to the volume of primary securities issued by non-financial corporate firms rose from 0.27 during 1951-56 to 0.37 during 1979-80 to 1981-82.

2. Growth in Underwriting of Securities:

The New Issue Market as a segment of capital market can be activated through institutional arrangements for the underwriting of new issues of securities. During the pre-independence period, the volume of securities underwritten was quite minimal due to lack of an adequate institutional arrangement for the provision of underwriting. Stock brokers and banks used to perform this function.

In recent years, the volume and amount of securities underwritten have tremendously increased owing to increasing participation of specialized financial institutions like LIC and UTI and the developed banks like 1FC1,1CICI and IDBI in underwriting activities. It is evident from the fact that the amount of securities underwritten was only 55 per cent in 1960-61, whereas at present it is about 99 per cent.

3. Growth in Response to the Offer of Public Issues of Shares and Bonds:

Traditionally investors in India being risk-investors had been reluctant to invest in shares of public limited companies. Hence, industrial securities as a form of investment were not popular in India before 1951. However, since 1991 public response to corporate securities has been improving. But equity-cult has yet to be developed in rural areas.

It is important to point out that the public response to new issues of shares and bonds depends upon number of factors such as rates of return on industrial securities relative to rates of return on non-marketable financial assets and real assets, government’s monetary policy and fiscal policy and above all legal protection to investors in recent years.

All the above mentioned factors have contributed to the growth of public response to new issue of corporate securities. In short, growing response to public issues has strengthened the Indian capital market. It is evident from the fact that the number of shareholders rose from 60 lakh in 1985 to 160 lakh in 1994.

4. Growth of Merchant Banking:

The role of merchant banking in India’s capital market can be traced back to 1969 when Grind lays Bank established a special cell called the ‘Merchant Banking’. Since then all the commercial banks have set up the ‘Merchant Banking Division’ to play an important role in the capital market.

The merchant banking division of commercial banks advises the companies about economic viability, financial viability and technical feasibility of the project. They conduct the initial ‘spade work’ to find out the investment climate to advise the company whether the public issue floated would be fully subscribed or under-subscribed.

The merchant banks in India act as the underwriter as well as the manager of new issues of securities. The Securities and Exchange Board of India (SEBI) regulates all merchant banks as far as their operations relating to issue activity are concerned. To sum up, the emergence of merchant banking has strengthened the institutional base of Indian capital market.

5. Growth of Credit Rating Agencies:

Of late, credit rating agencies have emerged in the financial sectors. This is an important development for the growth of Indian capital market. Investment Information and Credit Rating Agency of India (ICRA) rates bonds, debentures, preference shares, CDs (Corporate Debentures) and CPs (Commercial Papers).

As Credit Rating Information Services of India Ltd. (CRISIL) is a pioneer in credit rating, it rates debt instruments of banks, financial institutions and corporate firms. The credit assessment of companies issuing securities helps in the growth of New Issue Market segment of the capital market.

6. Growth of Mutual Funds:

Mutual funds companies are investment trust companies. Mutual funds schemes are designed to mobilise funds from individuals and institutional investors, who in exchange get units which Can be redeemed after a certain lock-in period, at their Net Asset Value (NAV). The mutual fund schemes provide tax benefits and buy back facility.

The Unit Trust of India (UTI) can be regarded as pioneer in the setting up of mutual funds in India. Of late, commercial banks have also launched in India mutual funds schemes. Can-stock scheme of the Canara bank and LIC’s scheme, such as Dhanashree, Dhanaraksha and Dhanariddhi are mutual funds schemes.

Since mutual funds schemes help to mobilise small savings of the relatively smaller savers to invest in industrial securities, so these schemes contribute to the growth of capital market. The total assets of mutual funds companies increased from Rs. 66,272 crore in 1993-94 to Rs. 99,248 crore in 2005 and to Rs. 4,13,365 crore in 2008. The investment of mutual funds in the secondary market influences the share prices in the stock exchange.

7. Stock Exchange Regulation Act:

The growth of capital market would not have been possible had the Government of India not legislated suitable laws to protect the investors and regulate the Stock Exchanges. Under this Act, only recognized stock exchanges are allowed to function. This Act has empowered the Government of India to enquire into the affairs of a Stock Exchange and regulate it’s working.

The Government of India established the Securities and Exchange Board of India (SEBI) on April 12, 1988 through an extra ordinary notification in the Gazette of India. In April 1992, SEBI was granted statutory recognition by passing an Act. Since 1991, SEBI has been evolving and implementing various measures and practices to infuse greater transparency in the capital market in the interest of investing public and orderly development of the securities market.

8. Liberalisation Measures:

Foreign Institutional Investors (FII) have been allowed access to Indian capital market. Investment norms for NRIs have been liberalized, so that NRIs and Overseas Corporate Bodies can buy shares and debentures, without prior permission of RBI. This was expected to internationalize Indian capital market.

To sum up, the Indian capital market has registered an impressive growth since 1951. However, it is only since the mid-1980s that new institutions, new financial instruments and new regularity measures have led to speedy growth of the capital market. The liberalisation measures under New Economic Policy (NEP) gave a further boost to the growth of Indian capital market.