Personal Finance

A detailed overview of the cut-off price and its role in an IPO

February 2, 2021

A detailed overview of the cut-off price and its role in an IPO

An investor may know about an Initial Public Offering (IPO), but wouldn’t exactly know about what makes up the whole and sole of the same. A cut-off price is one of the important aspects in regards to an IPO.

We are here to breakdown the term for you in a detailed manner and help you in making your investments smarter.

What is a cut-off price in an IPO

To simplify what might read like a complicated term for a newbie in the field of stock market investment, a cut-off price is a price at which shares get issued to the investors.

An IPO book building issue opens with a price range and there are both, minimum price and a maximum price for the issue. An investor can place bids for the desired quantity in multiples of the lot size with a price within the applicable range.

Two types of IPO pricing

In India, there are two types of mechanisms in regard to IPO pricing. Let us break it down for you to understand the cut-off price better.

Fixed price mechanism

In a fixed-price mechanism, the company decides the price of IPO in advance. It makes the IPO available to the public. Under this mechanism, the complete detail of investors belonging to various categories is declared on the date of the issue. Before the issue date, there is no way of knowing the demand for shares in this mode.

If the company opts to launch IPO with Fixed-Price Mechanism, the SEBI guidelines mandate that the company reserve 50% of total shares for retail investors.

Book Building Method

Under book-building-mechanism, the IPO price is not fixed at the beginning. At the time of launching an IPO, the company announces price bands. Investors make bidding with the price that ranges between these price bands.

It’s critical to make this mechanism essential to maintain high transparency, the company releases the data of investors daily.

Let’s get into the depths of what cut off price is

In the case of a book building issue, the issuer is expected to indicate the price band or a floor price in the red herring prospectus.

The actual discovered issue price can be any price in the price band or any price above the floor price and hence the issue price is coined as the “Cut off price”.

This is decided by the issuer and LM after considering the book and investors’ appetite for the stock. SEBI guidelines permit only retail individual investors to have an option of applying at the cut off price.

A little more about the cut-off price

For example, if the price bracket for an IPO is Rs.200 to Rs. 205 You apply for 10 shares at Rs. 202. If the determined issue price is Rs. 201 then you will receive an allotment at Rs. 201 since you were ready to subscribe to the issue up to Rs. 202.

Or else, if the determined issue price is Rs.204 then you will not receive an allotment of shares. In case you select cut-off, you are potential for allotment at any determined issue price.

Role of the cut-off price in an IPO

When an IPO is in its latest leg and towards closure, the investment bankers commence the process of price discovery. However, since there is no fixed price announced, there are various bids that happen at different prices.

Bankers decide the final price through a weighted average of all the bids received that are received in total. The final price that is decided is known as the cut-off price. In the case of popular issues that attract bids in excess of the shares on offer, the cut-off price is often the ceiling price.

After the Cut-Off price is fixed

Now that we have reached the last leg and the cut-off price is fixed, investors who made bids below the cut-off price are refunded their whole amount as they are not allotted the IPO.

Also, those who have made bids above the cut-off price and got allotment are refunded the excess amount.

If an investor wants to buy IPO at any cost, they have to opt for the option of buying at cut-off while making the application. This will ensure that the person is still eligible for the allotment, no matter where the cut-off price goes.

Conclusion

In the current scenario, almost all the companies opt for a book-building mechanism to fix the cut-off price of their shares. This method has proven to be flexible, efficient, and worked well for most cases.