What is the Offering Price?
Offering Price is the price decided by an investment banking underwriter when a company plans to publicly list shares in the stock exchange to raise capital. This price is based on the future earning potential of the company. However, the price shouldn’t be too high, then the shares might not be sold in full, and if it is too low, then the potential to raise more capital is lost.
Table of contents
Key Takeaways
- Offering price refers to the price an investment banking underwriter fixes when a company decides to list shares in the stock exchange to raise capital publicly.
- It is essential for those companies who want to give new securities or go public. In addition, listing a share is only possible with an offering price, as the investors may not have a price to place a bet on.
- The stock demand will immensely increase if it is very high. But, it is often manipulated by the underwriters and needs to display the company’s accurate valuation.
Explanation
When a company plans to go public, it needs to list shares in exchange. It is possible when the public buys the shares. So the process of listing is very complicated and requires several licenses. The license to make a company listed lies with underwriters. UnderwritersUnderwritersThe underwriters take the financial risk of their client in return of a financial fee. Market Makers like financial institution and large banks ensure that there is enough amount of liquidity in the market by ensuring that enough trading volume is there.read more are investment banks that help private companies to list their shares in the market. Listing is not limited to shares only. Underwriters also assist companies in listing bonds in the market. The most important thing for listing is the Offering price. This price is decided considering several factors like potential earnings of the company in the future, underwriter charges, condition of the economy to absorb the IPOIPOAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more, and several other factors. Once it is decided, shares are sold to potential Investors at this price. The money goes directly to the company after the deduction of Underwriter fees. So this is a primary marketPrimary MarketThe primary market is where debt-based, equity-based or any other asset-based securities are created, underwritten and sold off to investors. It is a part of the capital market where new securities are created and directly purchased by the issuer.read more activity.
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Source: Offering Price (wallstreetmojo.com)
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Example
Company XYZ is a privately held companyPrivately Held CompanyA privately held company refers to the separate legal entity registered with SEC having a limited number of outstanding share capital and shareowners. read more and plans to sell half of the stake to make itself public. How will the Offering Price be determined?
Solution
The foremost step of XYZ will be to find an underwriter. The underwriter works in two ways –
#1 – Best-Effort Basis
In this way, the underwriter says that he will try his best to sell all the company’s shares. If somehow all the shares are not sold, they are not liable. The Charge is comparatively less in this method.
As the liability is not with the underwriter, the underwriter will keep a higher Offering Price. It is because the underwriter’s commission will depend on the quantum of money raised. If more money is raised, then they will get more commission.
If the price is too high, then there is a risk that all the shares will not be sold.
#2 – Underwriting Basis
This effort is costly for the Underwriting firm. In this effort, the underwriting firm guarantees that they will buy all the unsold shares if they are not sold. There is a guarantee that all the shares will be sold in this method. So this is a risk for the Underwriting firm. They get more cautious in this method and keep the offering price low. Keeping the price low is the loss of potentialCapital Accumulation is the increase in the value of an investment or a financial asset, whether it is tangible or intangible. Interest, royalties, rent, dividend, capital gains are the most common examples of capital accumulation.read more capital accumulationCapital AccumulationCapital Accumulation is the increase in the value of an investment or a financial asset, whether it is tangible or intangible. Interest, royalties, rent, dividend, capital gains are the most common examples of capital accumulation.read more for the company. As the underwriter is keeping the price low, the company is losing the opportunity to generate higher capital.
Once the private company decides the method, the underwriting firm will do a thorough analysis of the company’s potential earnings in the future. There are several other factors that the Underwriting firm will consider, like the demand of the product that the company is selling, the condition of the economy, competing firms and their share price, underwriting fees, and many other factors. All the mentioned factors, once considered, will lead to the determination of the price. Once it is decided, the underwriter will float the circular to several potential investors.
Potential Investors will apply for IPO and will receive shares based on pro-rata. So the offering price is when potential investors get shares from the company.
Offering Price vs. Opening Price
Offering Price is the price that the underwriter determines. Once the price is determined, circulars are being floated by the underwriters to prospective investors and brokers. If an investor is willing to participate in the IPO, they subscribe for the number of shares they want. Underwriters then go through the subscriptions thoroughly and decide how many shares to give to which investor. Mostly the allotment is done on a pro-rata basis. Once the allotment is done, the shares get listed. On the first trading day, the shares are traded between the public. This price is the opening price.
On the first trading day, the share price is derived purely from the demand and supply of the stock. If the demand for the stock is high, then the Opening Price will be more than the Offering Price. Similarly, if the demand for the stock is less, then the Opening Price will be less than Offering Price. So the first day when the shares start to trade in public, that price is called Opening Price.
Advantages
- It is essential to make a company listed in public. Without Offering a price, it will be impossible to list a share as the investors will not have a price to bet.
- It throws the correct valuation of the company. It is compared with the Opening price to find the demand for the stock. If the Opening price is too high, then the demand for the stock is tremendously high.
Disadvantages
- Offering prices are often manipulated by the underwriters and don’t reflect the company’s correct valuation. At times underwriters keep the price too high to earn more commission from the capital raised. It, in turn, proves to be a loss for the investors who participated in the IPO as the opening price gets far below the offering price.
Conclusion
Offering price is significant for companies planning to issue new securities or go public. The price should be set so that the company raises enough capital to sustain its operations, and also, the investors should earn profit from those who are participating in the IPO. It should be correctly determined as a lot depends on the correct prediction.
The market runs on trust; once it is broken, it gets tough to rebuild. So if Investors see that the Opening price is always less than the Offering Price for most of the IPOs, they will stop participating in IPOs, and it will be impossible for companies to raise money from the market.
Frequently Asked Questions (FAQs)
An offering price is formed on the company’s legitimate prospects and fixed to draw attention from the general investing public. After the IPO, the market forces direct share prices and diverge from the offering price.
The Public Offering Price (POP) is the net asset value sum and the sales charge levied on an investor that must be paid for investing. For calculating the POP, the formula is NAV + SC = POP. In addition, the sales charge is added to the mutual fund’s net asset value to estimate the public offering price.
The offering price of a fund is at which new shares of the fund are made available for purchase by investors. However, when new fund shares are offered for purchases, additional fees or sales charges are added to the NAV to arrive at this price.
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