Section: 3 Initial Public Offerings (IPOs)
Sub Section: 3 Underwriting
In a typical underwriting arrangement, the investment bankers purchase the securities from the issuing company and then resell them to the public. The issuing firm sells the securities to the underwriting syndicate for the public offering less a spread that serves as compensation to the underwriters. In this procedure, which is called a firm commitment; the underwriter receives the issue and assumes full risk if the shares cannot be sold to the public at the stipulated offering price. The following flowchart depicts the relationships among the company issuing security, the lead underwriter, the underwriting syndicate, and the investors.
An alternative to the firm commitment is the best-efforts agreement. In this case, the investment banker does not actually purchase the securities but agrees to help the issuing company in selling the issue to the public. The banker simply acts as an intermediary between the public and does not bear any risk in case it is unable to resell purchased securities at the offering price. The best-efforts procedure is more common for initial public offerings (IPOs) of common stock, where the appropriate share price is less certain.
There is one more variation called an All or None Underwriting. Under this type of underwriting, the underwriter agrees to do his best to sell the entire issue by a certain date. All of the proceeds go into an escrow account. If the securities are not all sold by the certain date, the money is returned to the purchasers and the issue is canceled.
Corporations engage investment bankers either by negotiations or competitive bidding, although negotiation is far more common. In addition to the compensation resulting from the spread between the purchase price and the public offering price, an investment banker may receive shares of common stock or other securities of the firm.