Types of Underwriting Commitments
Once chosen, the underwriter will enter into an agreement with the issuer that will define who will bear most of the responsibility for selling and marketing the shares, as well as who will take on the financial risk of any unsold shares. The underwriter’s agreement may take various forms.
Firm commitment underwriting. In most cases, the investment bank will enter into a firm commitment underwriting with the issuer of the securities. A firm commitment underwriting is an agreement that the underwriter will purchase all the securities at a discount and then sell the securities to the public at a fixed public offering price. In this type of agreement, the underwriter is responsible for the marketing and sale of the securities and assumes all the risk of the offering, including the liability of any unsold shares. The offering is conducted in a single day. This is the most common type of underwriting commitment for a corporate offering, and it is preferred by most issuers.
Firm commitment underwritings may be undertaken in one of two ways:
- 1. In a competitive bidding process, the company solicits underwriters to submit a sealed bid for the underwriting contract. The issuer awards the contract to the underwriter with the most competitive price and contract terms. Competitive offerings are common for new issues of municipal bonds and public utilities but rare for corporate offerings.
- 2. With a negotiated bid, the company elects to negotiate with a single underwriter for the contract. Negotiated offerings are the most common type of corporate underwritings.
Best-efforts underwriting. If the issuer is a smaller, less well-known company or a private placement, it may engage in a best-efforts commitment with its underwriter. This is also referred to as a contingency agreement. In this kind of agreement, the underwriter agrees to use its best efforts to sell the issuer’s securities, but the underwriter does not g