We noted that once the book-building process is complete, the company ownership and investment bankers gather for a meeting to determine the price of the shares to be listed and their allocation to investors.
Every investor is willing to buy a certain number of shares at a price. If the demand for shares at the IPO price is higher than the actual number of shares to be sold, some investors will not receive any shares. In contrast, others will be allocated a portion of the shares they expressed interest in purchasing. Here is a chart that gives you an idea of investors’ demand at different price points.
Some investors are willing to buy more shares at $13 and fewer at $14. Demand at $15 decreases a bit further and so on. One would think this is a no-brainer. Shareholders and bankers should choose the highest price point that allows the sale of the targeted number of shares.
Right?
Not necessarily.
This isn’t always easy to explain to owners without previous experience in the process. Several factors come into consideration. First, investors must not be left with a bitter taste after the IPO. The company will need to sell the stock at a slight discount, allowing investors to profit in the first few hours of trading.
In addition, a small discount increases the number of investors willing to buy the company’s shares, providing extra liquidity in the market. Liquidity helps stabilize the stock price after the listing takes place. It’s crucial to allocate as many shares as possible to investors who believe in the equity story and are buying with a long-term holding perspective. The apparent criteria for allocation are the price limit and quantity of shares desired by a given investor and another important factor is the timing of the investor’s order.
Did they submit an order at the beginning of the book-building process or at the very end when there was already momentum for the stock?
Bankers consider how involved a given investor was in the IPO process, whether they’ve asked reasonable questions, and the overall vibe and chemistry with company management during one-on-one meetings. Another significant factor is an investor’s previous IPO track record.
What is their reputation?
Did they have a short-term perspective?
Did they purchase the amount of stock indicated in the book-building process?
These are some of the criteria investment bankers consider, among a few others, when discussing the allocation of shares to investors. Sometimes it’s evident that an investor has done the necessary work to understand the company. They could also have beneficial insight during the book-building process and provide valuable information regarding market sentiment, possible concerns, and future perspectives.
We can recap by saying bankers typically prefer the following pecking order. Institutional investors with a long-term horizon and strong market credibility. Investors who placed their orders earlier in the book-building process. Investors who understand the company have done the necessary due diligence and have expressed interest during meetings and presentations, and of course, investors who have proven reliable and have a solid IPO participation track record.
This isn’t a process entirely driven by the stock price offered. We should remember that the leading bank proposes an allocation and then it’s up to the company ownership to decide on said allocation.
