Book building is a process used in an initial public offering to determine the demand for shares of a given company's stock and to determine the price at which to offer a share of stock. It involves polling institutional investors, such as brokerage houses that manage pension funds, mutual funds, and hedge funds, to determine those funds' potential interest in buying a share of a company about to go public. It is generally performed by an underwriter, who is a financial expert involved in the process of an initial public offering.
When a company wishes to become a public company and sell stocks on a stock exchange or index, such as the New York Stock Exchange (NYSE), it generally must go through a number of steps. These involve making disclosures in regards to its financial picture and providing detailed information on the operations of the company. The company's initial offering of stock shares, as well as its release of this financial data, is referred to as an IPO or initial public offering, since it is the first time the shares of the given company are made available for sale.
When an IPO occurs, the company must determine how to price each share of stock. Since the company has not been sold on an open market before, this pricing can be difficult. Book building is the process used to help ensure the stock is offered for the correct price. If a stock is offered at too low of a price, the company will not benefit as much as it could from the IPO and will not raise as much capital as the offering had the potential to raise. If the stock is priced too high, there may be insufficient demand to purchase, causing the company to not make the full amount of money it was seeking and potentially causing the prices of existing shares to fall even further on the open market as a result of the lack of demand.
Book building aims to avoid these undesirable outcomes. The process of book building involves contacting fund managers — those investment bankers and brokers who manage money for other individuals in the form of a mutual fund or hedge fund — and asking those institutional investors how many shares they would be willing to buy and at what price. Essentially, book building is building a list of individuals who wish to buy a stock before it is offered, so the demand can be assessed and the price of the stock appropriately determined.