What is Offering Price?
Offering Price is the price that is decided by an investment banking underwriter when a company plans to go public list shares in the stock exchange for raising capital. This price is based on 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.
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 IPOIPOInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes.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 and charges. 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)
Example
Company XYZ is a privately held company and is planning 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 shares of the company, if somehow all the shares are not sold, then they are not liable. The Charge is comparatively less in this method.
As the liability is not with the underwriter, so the underwriter will try to keep a higher Offering Price. It is because the commission of the underwriter 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 in case all the shares are not sold. So this is a risk for the Underwriting firm. They get more cautious in this method and tries to keep the offering price low. Keeping the price low is the loss of potential 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 so the company is losing on the opportunity of generating higher capital. There is a guarantee in this method that all the shares will be sold.
Once the private company decides the method, then 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 offering price is the price at which potential investors get shares from the company.
Offering Price vs. Opening Price
Offering Price is the price that is determined by the underwriter. 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, then they subscribe for the number of shares they want. Underwriters then go through the subscriptions thoroughly and decide on how many shares to be given 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 start to trade 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 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 doesn’t reflect the correct valuation of the company. At times underwriters keep the price too high just 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 than offering price.
Conclusion
Offering price is significant for companies planning to issue new securities or planning to go public. It should be correctly determined as a lot depends on the correct prediction. The price should be set as such that the company raises enough capital to sustain its operations, and also, the investors should earn profit who are participating in the IPO.
The market runs on trust; once it is broken, then 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, then they will stop participating in IPOs, and it will be impossible for companies to raise money from the market.
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