Pricing an IPO

Pricing an IPO is a tricky endeavor. The process starts with appointing a lead manager that will be act as a bookrunner. This bookrunner will help determine the appropriate price for shares using two methods. One is the fixed price method, which, as it names suggests, fixes a price for the shares, and the other is called book building, where the bookrunner runs an analysis of confidential investor demand data and compiles it for the company.

There have been examples when companies have been underpriced during an IPO. This “initial underpricing” is employed to generate interest in the stock when it starts to be traded publically. This allows investors to flip these shares, or sell them quickly for a profit, which can lead to substantial profits for these investors who’ve bought shares at the offering price. This also ensures that the company receives the funding it needs quickly, and that shares don’t stagnate. However the downside is that the underpricing can result in lost potential capital for the company. There is one example, where Bear Stearns underpriced the stocks of theglobe.com at $9 a share, a price which when the shares started trading increased by 1000% to $97, dropping to $63 at the end of the day. The company managed to raise $30 million from the offering, but some estimate that this number is $200 million short.

Of course, underpricing is done to ensure a safe margin where the most amount of capital can be brought in for the issuing company. This is done in order to avoid overpricing, which can lead to a less than expect showing of interest. And even if the underwriters manage to sell all of the shares, the share price might drop on the first day of trading, resulting in losses for the initial investors, many of whom are important clients for the underwriters. An example of this would be the Facebook IPO.

The pricing of an IPO requires many factors to be taken into consideration. The price of an IPO has to be low enough to entice initial investors, but high enough to bring in enough capital for the issuing company. To reach this optimal price, the underwriters arrange share purchase commitments from leading institutional investors. Some researchers believe that underpricing an IPO is less of a deliberate act on the part of the underwriters or issuers and more of an overreaction of the investors.

Chris Benjamin, Rogue CFO
chrisb@roguecfo.com
http://www.roguecfo.com

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