What it means
When a company decides to sell securities to the public, it needs a price. The issuer and its underwriters set that price after meeting investors, gauging demand and comparing the business with similar listed companies.
The price is first discussed as a range, such as $18 to $22 a share, and then fixed once the books are built. If demand is strong, the final price can be set at the top of the range or above it, and if demand is weak, it may be cut or the deal postponed.
The public offering price is different from the amount the company receives. Underwriters buy the securities from the issuer at a discount and resell them at the public offering price, and the gap between the two is the underwriting spread or gross spread, which pays for their work and risk.
Spreads are often in the mid single digits as a percentage of the amount raised, though they vary with deal size and type. The price also becomes a reference point for the market.
On the first day of trading, investors watch whether the shares open above the offer price, which suggests good demand, or below it, which can cast a shadow over the issue. For a finance team, the price drives how much is raised and how much the existing owners are diluted.
Setting it too low leaves money on the table, while setting it too high risks a weak debut and unhappy investors. The nuance is that a lower price is sometimes chosen on purpose, to reward early buyers and encourage a strong first day.
Companies and their advisers weigh that goodwill against the extra capital they could have raised. A modest first-day rise is widely seen as healthy, while a very large jump suggests the company left money behind.
In practice
Real-world examples.
Example
A biotechnology company sets its public offering price at $16, above its marketed range of $13 to $15, because orders from investors are several times the number of shares available. The finance team raises more money than planned and reduces its need for later funding. Investors in the offering also see a healthy first-day price, which supports future fundraising.
Example
A utility sells bonds to the public with an offering price of 99.5 for every 100 of face value. Investors pay slightly less than the face value, and the lower price gives them a slightly higher yield than the stated coupon. The utility records the bonds at the issue price and amortises the small discount over the life of the debt.
Example
A start-up's shares open 30% above the public offering price on the first day. The founders are pleased with the demand, but the chief financial officer notes that the company might have raised more money by pricing higher. The board accepts this as a fair cost of building goodwill with new shareholders.
Formula
Calculation
Net proceeds per share = public offering price - underwriting spread per share
Suppose the public offering price is $25 a share and the underwriting spread is 6%. The spread per share = 25 x 0.06 = $1.50. Net proceeds per share = 25 - 1.50 = $23.50. If the company sells 10,000,000 shares, it receives 10,000,000 x 23.50 = $235,000,000, while investors pay 10,000,000 x 25 = $250,000,000 in total. The difference of $15,000,000 goes to the underwriters.Case study
Seen in the real world.
Summit Logistics Group is an illustrative, fictional freight company preparing a listing. Its bankers suggested a price range of $14 to $16 a share, and the founders hoped for the top of the range.
During the roadshow, a handful of large investors asked for much bigger allocations than were available. The bankers recommended pricing at $17 and the board agreed after confirming that the higher price still left room for the shares to rise. Allocations were then fixed so that long-term holders received the largest orders.
The company raised about 12% more than first planned and the shares traded modestly higher on the first day. The illustrative lesson is that the offering price is a negotiation between raising as much money as possible and leaving a fair reward for new investors. Summit's chief financial officer later wrote the experience into the company's template for future share issues.
Watch out
Common mistakes.
- Assuming the company receives the full offering price on every share, when the underwriters keep a spread out of it.
- Treating the first-day trading price as the offering price, when the two can differ widely.
- Believing a higher price is always better, since an overpriced issue can fall in the market and damage the company's reputation with investors.
Questions
People also ask.
Who sets the public offering price?
The issuer and its lead underwriters agree it, normally after the sales team has measured demand from large investors. The decision is signed off by the board or a pricing committee on the evening before trading starts.
What is the underwriting spread?
It is the difference between the price the public pays and the price the underwriters pay the issuer, and it covers their fees and risk.
Can the offering price change after it is announced?
A price range can be revised up or down before the deal closes, but once the final price is set and sales begin it is fixed for that offering.
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