IPO allocation is the way that companies offering stock shares through initial public offerings decide which investors will receive shares and what the price of those shares will be. This is necessary when the number of shares being offered is less than the number of bids received for the stock. There are several different methods that a company may use for the IPO allocation. Chief among these are the fixed-price method, in which the price of the stock is known in advance, the Dutch Auction method, which allocates the stock based on bidding prices, and the book building method, which sets the price after seeing all bids in a specific price range.
Companies traded on the stock market have shares of stock which can be bought and sold by investors. But there are also newer companies which wish to get to the stock market for the first time. To do that, they must have an initial public offering, or IPO, which makes their stock available to public investors. Determining how many shares will be given to each investor and at what price is known as IPO allocation.
At times, IPO allocation is simply a matter of selling shares to people based on a predetermined price agreed upon by the company and the underwriter, which is usually a large brokerage firm which sponsors the offering. This fixed-price method is particularly effective if the company does not expect to sell all of its shares, which means the stock is under-subscribed. If there is more demand than supply for the initial shares, the stock is said to be oversubscribed.
In the book building method of IPO allocation, investors do not know what the eventual price of the stock shares will be when they bid. Instead, they are asked to bid on the shares within a certain price range. The company and underwriter then use the bidding information to come up with a price that best suits the IPO. Investors who made bids are awarded shares at this price, which could be different than their initial bid price.
For the Dutch Auction method, IPO allocation is based on the price of the bids. For example, imagine there are 200 shares of a stock being offered. The 200 bidders that made the highest bids would all get shares, and the price would be set at the lowest amount bid by these top 200. Obviously, there might be bidders who want multiple shares, but they might be not be able to get them all. If there was a person in this example who had made a bid for 10 shares at the 196th highest bidding price, he would only get five of his desired shares, since the other five would exceed the 200 shares available.