Introduction
IPO refers to a company going public and is a special place for any business to get into. It changes the ownership of the business from private to public. One of the most important terms associated with an IPO is the cut-off price.
In this post, we will discuss what cut-off price means in the context of an IPO, how it can be determined, why it is important, and how it can affect both investors and the issuing company.
Understanding IPO Pricing
What is an IPO?
Before breaking down the cut-off price, one has to understand what an IPO is all about. An IPO is the initial public offering of shares in an organization and the company going for floating is a private one until then.
The IPO enables the company to sell shares to the public and get the necessary capital to finance its plans and operations from its shareholders.
Some of the phases of the process include undertaking searches for investment banks that might be willing to underwrite the IPO, submitting some essential documents to the relevant regulatory authorities and the determination of the price that each share will be sold for.
What Are The Differences Between Fixed Price And Book Building?
There are two primary methods of pricing shares in an IPO: fixed price and book building.
1. Fixed Price Method
Here the company in consultation with the underwriters arrives at a single fixed offer price at which the shares are sold to the public.
2. Book Building Method
This is a more flexible approach and the final price is set depending on the market acceptance based on institutional and accredited investors. Here, the offering is accompanied by a price range through which the investors can make bids during its offer.
What is the cut-off price?
This is the price that investors bid for and at which shares are sold to them at the end of an IPO through book building facilitation. It is the cut off price in IPO that will balance the quantity demanded and quantity supplied of a particular type of shares.
In its undertakings, the cut-off price is set during the book building period of the offer. Here’s how it works:
1. Price Band: It is the determination of the price within which the company together with its underwriters allows investors to make an offer. For instance, upon adopting a price band between $10 and $15, in the event of an offer, investors can enter any bid in between the band.
2. Bidding: Buyers use offers to tender indicating the desired lot and offering to purchase it at a target price within a certain range.
3. Book Building: These bids help the book runners to understand the demand of the shares in relation to different price levels.
4. Final Price: The cut-off price is fixed at a level where the highest number of buyers and sellers of the shares and it is the price at which the issue is made.
Significance of cut-off price
For the Issuing Company
The cut-off price is of a significant interest to the issuing company since it determines the direct capital to be received. A higher cut-off price will bring in more funds; Whereas, a lower cut-off price shows lesser demand in the market.
It means here that the company needs to find a price at which it can maximize the amount of capital that can be raised and at the same time try to make the shares as appealing as possible to its clients.
For Investors
For investors, understanding the cut-off price is essential for several reasons:
1. Investment Decisions
Due to regulatory measures put in place to protect informed investors, there are many retail investors that place bids at the cut-off price in order to secure an allotment. This approach is relatively simpler in their decision-making process as they do not have to speculate about the final price.
2. Allotment
Some companies and their investors are awarded stocks based on the price bid at or above the cut-off price while others with bid prices below the cut offer price may not be awarded stocks. Therefore using the cut off price it provides an investor with probability of an allotment.
3. Market Sentiment
The cut-off price could convey the total demand as well as the market conditions needed for the IPO. When the cut-off price is higher compared to the price band, there is a probability that investors are enthusiastic to invest in the new issue, and, conversely, if the cut-off price is lower compared to the price band, then there is a probability that investors are being cautious or there is low interest.
Conclusion
IPO is often characterized by a process referred to as the ‘book building’, where ‘cut off price’ is one of the most important aspects to be determined and represents a point at which demand equals supply.
For the issuers, it defines the amount of capital that has to be pulled; for the investors, it impacts the bidding strategies and probabilities of being issued an allotment.
