The differences that exist between firm commitments and best efforts underwriting are so substantial that they can often impact the success of an underwriting, and have an affect on the issuer. The information provided below is designed to be an introduction to these arrangements. If you have further questions regarding either, it’s strongly suggested that you consult with a qualified professional.
What is a firm commitment?
A firm commitment is when a written agreement exists between an investment bank and the issuer of the securities. This agreement outlines the bank’s purchase of the securities from the issue, so that these securities can be offered to the public.
The investment banker serves as the underwriter, and thus is obligated to earn profit from the difference between the purchase price and the public offering price. The purchase price is determined one of two ways:
- Competitive bidding
With this agreement, the issuer knows how much money it will receive from the offering, at the moment when the registration statement is declared. This type of scenario is typically performed when an investment bank obtains indications of interest, making it clear that it will be able to resell shares that it purchases.
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What is best efforts?
With a best efforts agreement, investment bankers serve as agents and agree to invest their “best efforts” into selling an issue to the public. Unlike a firm commitment, the bankers (or agents) aren’t buying the securities. Rather, the agents have an option to buy, as well as an authority to sell the securities.
Contracts can vary with best efforts. It is possible for agents to buy up enough shares to cover their sales to clients. On the other hand, they can also cancel the issue that isn’t completely sold, and thus forego the fee.
Because of this, issuers tend to have an increased risk, as well as delays, when it comes to best efforts underwriting. As a result, you’ll typically find best efforts agreements handled by firms with specific experience working with new and young companies.
Understanding the standby commitment
Another agreement worth understanding is the standby commitment, which involves a corporation (serving as issuer) and an investment-banking firm (serving as the standby underwriter).
In this agreement, the corporation contracts to purchase any portion of a stock issue offered to shareholders in what’s called a rights offering that’s not subscribed to during the standard 2-4 week standby period. A right entitles its holder to purchase a specified amount of shares prior to a public offering, and typically at a lower price than what will be offered to the public.