Firm Commitment Underwriting
• Issuer sells entire issue to underwriting syndicate
• Syndicate resells issue to the public
• Underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold
• Syndicate bears the risk of not being able to sell the entire issue for more than the cost
• Most common type of underwriting in the United States
This is a good place to review the difference between primary and secondary market transactions.
Technically, the sale to the syndicate is the primary market transaction, and the sale to the public is the
secondary market transaction.
Three basic types of underwriting are involved in a cash offer: firm commitment, best efforts, and Dutch
auction.
Firm commitment underwriting – the underwriting syndicate purchases the shares from the issuing
company and then sells them to the public. The syndicate’s profit comes from the spread between the prices,
and it bears the risk that the actual spread earned will not be as high as anticipated (or may not even cover
costs). This is the most common type of underwriting in the United States.
For a new issue of seasoned equity, more than 95 percent of all such new issues are firm commitments.
Slide 10
15-10
Best Efforts Underwriting
• Underwriter makes “best effort” to sell the securities at an agreed-upon offering price
• Issuing company bears the risk of the issue not being sold
• Offer may be pulled if not enough interest at the offer price
– Company does not get the capital and they have still incurred substantial flotation costs
• Not as common as it used to be
Best efforts underwriting – the underwriters are legally bound to make their “best effort” to sell the
securities at the offer price, but do not actually purchase the securities from the issuing firm. In this case,
the issuing firm bears the risk of the market being unwilling to buy at the offer price.
The underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer.
This form of underwriting has become uncommon in recent years.
Slide 11
15-11
Dutch Auction Underwriting
• Underwriter accepts a series of bids that include number of shares and price per share.
• The price that everyone pays is the highest price that will result in all shares being sold.
• There is an incentive to bid high to make sure you get in on the auction but knowing that you will probably pay a lower price than you bid.
• The Treasury has used Dutch auctions for years.
• Google was the first large Dutch auction IPO.
Dutch auction underwriting (also known by the uniform price auction) – the underwriter does not set the
offer price. Instead, a series of bids is solicited from potential investors and the price that is paid by everyone
is the price that will result in all shares being sold. The incentive is to bid high to guarantee that you get in
on the offer price, knowing that you will only pay the lowest accepted price. The U.S. Treasury has sold
bills, bonds, and notes using the Dutch auction process for many years. Google is the highest profile Dutch
auction IPO to date.
Buyers:
• Bid a price and number of shares
Seller:
• Work down the list of bidders
• Determine the highest price at which they can sell the desired number of shares
All successful bidders pay the same price per share.