Going public can be a daunting process, with multiple steps to take, decisions to make, and involvement from many constituents – management teams, boards of directors, investors, lawyers, bankers, and more. All these constituents have different opinions, objectives, and areas of expertise. The culmination of all of this is the pricing of the IPO which is far from an exact science and is impacted by many different inputs and factors (for more, see this previous blog). We often hear of an “upsized” IPO and/or “pricing above the range,” but how are these parameters determined, who determines them, and why? In this blog post, we will shed light on how the magic of a final IPO price is determined.
Building the Book
The level of interest in an IPO indicated by potential investors is arguably the most fundamental factor in determining the IPO price. ‘‘Building the book’’ is the common terminology used to describe the underwriters’ process of obtaining indications of interest, which may include a specific price and quantity matrix of desired share allotment, from potential investors. During the roadshow, as management presents its story to gain interest in the company’s IPO, the underwriters’ capital market groups follow up with the potential investors to gauge interest in the IPO by recording the number of shares each investor would be willing to purchase and how much the investor would be willing to pay. This allows the underwriters to gauge investor demand for the offering once the roadshow concludes, as well as the number of shares that can be sold (including the over-allotment option) and what the optimal price will be. The underwriters look at all indications and the matrix of shares desired at different potential price points to determine the optimal offering price and how many shares to offer.
IPO Price
The book is only one of several factors that determine the final IPO price and shares offered. Other factors include the following:
- Quantitative factors including the company’s current sales, expenses, earnings, and cash flow. Projected earnings are also factored in.
- Valuation multiples comparable to the company’s industry peers
- The size of the current and near-future market for the product or service that the company produces
- The marketability of the company’s stock in the current economic environment
- The underwriters’ view of current market, industry, and economic conditions and developments. If stock market or industry conditions deteriorate, even a book that had been strong may be impacted.
With all of this, the underwriters must also balance the interest of multiple involved parties. The company’s executives and early investors want to price the shares as high as possible in order to provide the highest return and raise as much capital as possible. On the other side, the buyers, led by institutional investors, want the lowest possible price in order to increase the chances of a positive return, not only in the immediate aftermarket, but in the long-term as well.
In a well-received offering, buyers may be willing to pay at the high-end of the filing range or above in order to start building their long-term positions. In a scenario like this, the investment bank will go back to more price sensitive buyers and let them know that other buyers are willing to pay more, and unless they are as well, they may receive a smaller allocation or miss out altogether on the IPO. By then pricing above the mid-point of the filing range, the company will raise more money than originally expected without further diluting the private investors, management team and other company employees who own stock.
Interestingly, for an IPO that is oversubscribed and prices at the mid-point of the filing range or higher, there is an expectation that the stock will trade higher in the immediate after-market. And while this appears to leave the issuing company with less money raised, this so-called IPO discount helps to entice investors to buy into a company that has not yet proven itself as a public entity and provide an attractive entry point for building a position. In addition, as one of the goals of an IPO is to create liquidity, it is a positive to see the stock trade up and have active volume.
Looking further at price increases in the aftermarket, much of the buying demand is a result of long-term investors receiving only a portion of the necessary shares to build a meaningful position in their portfolio. As an example, a fund may only receive 50,000 shares on the IPO, but need an additional 200,000 shares to build a meaningful position. They may then choose to build this position over the first few days of trading when liquidity is highest with an end result of a 250,000 share position with a volume weighted average price (VWAP) that is nearer to the closing price over the first few days than it is to the IPO price. While the lead underwriters will work to price an offering at the highest possible price while balancing the need for aftermarket performance, pricing remains more of an art than science. Unknown factors such as short-term traders, retail demand and even unknown long-term buyers can all cause a stock to rise more than expected after pricing.
Shares Offered
The other input that can be modified for the final IPO terms is the total number of shares offered, with the main drivers of this number being the quality and breadth of the investor demand along with the total desired funds to be raised. Upon filing the S-1 with the SEC, the issuing company indicates the number of shares to be registered and pays a registration fee that is based on that number of shares multiplied by the high-end of the filing range. The Securities Act of 1933 (Securities Act), does provide that an issuer may upsize or downsize an IPO if the changes in volume and price represent no more than a 20 percent change from the maximum aggregate offering price set forth in the fee table in the effective registration statement.
While strong demand can lead to a higher IPO price, it can also lead to more shares being offered. There are scenarios where buyers may be price sensitive even in the face of strong demand, but if the banks feel the book contains breadth and quality of the investors who want to build long-term positions, they may recommend upsizing the deal. By doing so, the largest, high-quality investors can be given meaningful allocations which they can build on in the aftermarket.
Of course, the number of shares offered will impact capitalization and ownership/dilution, so this must be carefully considered. It will be of utmost importance to company insiders, investors and individuals who held shares pre-IPO. So, the shares offered is an important input in the big picture and can impact the capitalization, ownership, and future issuances for the company.
Ultimately, pricing an IPO is an exercise in balancing the interests of multiple parties while optimizing the outcome and predicting market reactions. While there is no exact science to follow, underwriters are well-versed and experienced in the many inputs and dynamics that lead to a successful IPO.
Our team is here to answer any questions you may have about pricing IPOs and advise you in what to expect when it comes time to price your offering. Contact us to learn more.
Debbie Kaster, Managing Director
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