What it means
When a company decides to sell shares to the public for the first time, it hires investment banks, called underwriters, to manage the process. The banks test demand among large investors, a step known as bookbuilding, and propose a price range.
The final offering price is set shortly before the shares begin trading. Several factors guide the price.
Underwriters look at the company's earnings and growth, the value of similar listed companies, and how many investors want to buy. If demand is strong the price is set at the top of the range or above it, and if demand is weak it may be lowered or the deal postponed.
The offering price determines how much the company raises. Gross proceeds equal the number of shares sold multiplied by the price, and the underwriters keep a fee, called the spread, which is usually a few per cent of the amount raised.
The company also pays legal, audit and listing costs. The first-day trading price can differ from the offering price.
If the shares trade well above it, the company left money on the table because it could have sold at a higher price. If they trade below it, early buyers lose money and the underwriters may need to support the price.
The term is also used for follow-on offerings, where a listed company issues more shares, and for bonds and funds sold at a set price. In each case, it is the price paid by the first investors rather than the price that later trades take place at.
Finance teams model different prices to see how much the company raises and how much of the business existing owners give up.
In practice
Real-world examples.
Example
A software company sets a price range of $18 to $22 and receives orders for three times the shares available. The underwriters set the offering price at $22. The shares rise on their first day of trading.
Example
A listed manufacturer issues 5,000,000 new shares at an offering price of $30 to fund a new plant. It raises $150,000,000 before fees. The finance team compares the cost of this funding with a bank loan before deciding, because new shares dilute existing owners while a loan adds interest and a repayment date.
Example
A real estate fund offers units at $10 each to investors during its launch period. A total of 4,000,000 units are sold, raising $40,000,000. The price is fixed until the offer closes, so every investor in the launch period pays the same amount per unit regardless of when they apply.
Formula
Calculation
Gross proceeds = number of shares offered x offering price
Net proceeds = gross proceeds - underwriting spread - other offering costs
A company offers 10,000,000 shares at an offering price of $20. Gross proceeds = 10,000,000 x 20 = $200,000,000. If the underwriting spread is 5%, the fee = 200,000,000 x 0.05 = $10,000,000. Net proceeds before other costs = 200,000,000 - 10,000,000 = $190,000,000.Case study
Seen in the real world.
Skyline Robotics is a fictional company used to illustrate the offering price. In this illustrative story, it planned to sell 8,000,000 shares in an IPO with a price range of $14 to $16. Strong demand led the underwriters to set the offering price at $16, giving gross proceeds of 8,000,000 x 16 = $128,000,000.
On the first day the shares closed at $22, which meant that investors who received shares made a quick gain. Skyline's founders were pleased with the interest but noted that a price of $20 might have raised $32,000,000 more. The finance director used the experience to explain to the board how the offering price balances the company's need for funds with the need to attract investors.
For the finance team, the main lesson was to model several scenarios before the roadshow. The model showed proceeds, the share of the company sold and the effect on earnings per share at prices from $14 to $20, which made the board's decision on the final price quicker and better informed.
Watch out
Common mistakes.
- Confusing the offering price with the market price. The offering price is the price for the first sale, and the market price changes with trading afterwards.
- Counting gross proceeds as the cash the company keeps. Underwriting fees and other costs reduce the amount received.
- Assuming a higher offering price is always better. If the price is too high, the shares may fall after listing and harm the company's reputation.
Questions
People also ask.
Who sets the offering price?
The company and its underwriters agree it, usually after testing demand among investors.
What is the underwriting spread?
It is the fee paid to the banks that manage the offering, generally a percentage of the money raised.
Is the offering price the same as the IPO price?
Yes, for an initial public offering the two terms mean the same thing.
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