Underwriting

Types of Underwriting Commitments

Underwriting is the process by which investment banks facilitate the issuance of new securities by purchasing them from the issuer and distributing them to investors. The underwriter serves as an intermediary between the issuer (who needs capital) and investors (who seek investment opportunities). The type of underwriting commitment determines how risk is allocated between the underwriter and the issuer.

Firm Commitment Underwriting

In a firm commitment underwriting, the underwriter purchases the entire issue from the issuer at a negotiated discount to the public offering price and assumes the risk of reselling the securities to investors. If the underwriter cannot sell all the securities at the offering price, it must hold the unsold portion in its own inventory, potentially at a loss. This is the most common type of underwriting for large public offerings.

The firm commitment structure provides the issuer with certainty of proceeds: the issuer knows exactly how much capital it will raise regardless of investor demand. In exchange for assuming this risk, the firm commitment underwriter earns a larger compensation (the underwriting spread) compared to other commitment types.

Best Efforts Underwriting

In a best efforts underwriting, the underwriter agrees to use its "best efforts" to sell the securities on behalf of the issuer but does not commit to purchasing unsold shares. The underwriter acts as an agent rather than a principal. Any securities that remain unsold are returned to the issuer. The issuer bears the risk that the offering may not be fully subscribed.

Best efforts underwriting is more common for smaller issuers, speculative offerings, or when market conditions are uncertain. The underwriter earns a selling commission on each share sold but does not assume the financial risk of unsold shares.

All-or-None Underwriting

An all-or-none (AON) underwriting is a variation of best efforts in which the entire offering must be sold within a specified period or the deal is cancelled and all investor funds are returned. This structure provides a minimum capital raise threshold. If the underwriter cannot sell every share, the offering fails entirely. During the offering period, investor funds are held in escrow until the offering is either completed or cancelled.

Mini-Max Underwriting

A mini-max (or "part-or-none") underwriting sets both a minimum and maximum offering size. The minimum must be achieved for the deal to proceed, but the underwriter can continue selling up to the maximum amount. Investor funds for shares below the minimum are held in escrow; if the minimum is not met, funds are returned. This structure provides the issuer with flexibility while ensuring a minimum capital raise.

The Underwriting Spread and Compensation

The underwriting spread (also called the "gross spread" or "underwriting discount") is the difference between the price the underwriter pays the issuer for the securities and the public offering price at which the securities are sold to investors. This spread represents the total compensation earned by the underwriting syndicate for distributing the securities.

Components of the Spread

The underwriting spread is divided into three components:

1. Management Fee: Paid to the lead underwriter(s) for managing the entire offering process, including due diligence, structuring, SEC registration, marketing, pricing, and allocation. Typically 20% of the total spread.
2. Underwriting Fee: Paid to all members of the underwriting syndicate in proportion to their underwriting commitment (the number of shares they agreed to purchase). This compensates for the risk of purchasing the securities. Typically 20% of the total spread.
3. Selling Concession: Paid to any firm that sells shares to investors, including syndicate members, selling group members, and the lead underwriter's own sales force. This is the largest component, typically 60% of the total spread.

For a typical IPO, the gross spread is approximately 7% of the offering price ("the 7% solution"), though this varies based on deal size, complexity, and competitive dynamics. Larger offerings and debt offerings typically have lower percentage spreads.

Reallowance

The reallowance is a portion of the selling concession that may be offered to non-syndicate members (dealers who are not part of the underwriting syndicate or selling group) for selling shares. The reallowance is the smallest component of the spread and is offered at the discretion of the managing underwriter. Dealers selling at the reallowance do not have any underwriting obligation or syndicate membership.

Syndicate Formation and Agreements

For large offerings, the lead underwriter forms a syndicate of investment banks to share the risk and distribution responsibilities. The syndicate is governed by several key agreements:

Agreement Among Underwriters (AAU)

The Agreement Among Underwriters is a contract among the syndicate members that establishes the terms of their participation, including each member's underwriting commitment (number of shares), the allocation of the spread among members, the lead underwriter's authority to manage the offering, stabilization provisions, and indemnification obligations. The AAU defines whether the syndicate operates on a divided (Western) or undivided (Eastern) basis:

• Western (Divided) Account: Each syndicate member is responsible only for selling its own allocation. If a member sells its portion, it has no further obligation, even if other members have unsold shares. The risk is divided among members based on their individual allocations.
• Eastern (Undivided) Account: Each syndicate member is responsible for its proportional share of any unsold securities across the entire syndicate, even if that member has sold its own allocation. This creates greater collective responsibility and is more common in municipal bond underwriting.

The Underwriting Agreement

The Underwriting Agreement is the contract between the issuer and the lead underwriter (on behalf of the syndicate). It is executed on the pricing night and specifies the number of shares to be purchased, the public offering price, the underwriting discount, representations and warranties of the issuer, conditions to closing (delivery of legal opinions, comfort letters, officer certificates), indemnification provisions, and the overallotment option. This agreement is the definitive document governing the offering.

The Selling Group

Beyond the syndicate, the lead underwriter may invite additional broker-dealers to participate in a selling group. Selling group members help distribute the securities but do not assume underwriting risk. They earn only the selling concession for shares they sell. The selling group agreement specifies the terms and conditions of their participation.

Regulatory Framework for Underwriting

Underwriting activities are subject to extensive regulation by both the SEC and FINRA. Key regulatory requirements include:

FINRA Corporate Financing Rules

FINRA Rule 5110 (the Corporate Financing Rule) governs the compensation and arrangements of underwriters in public offerings. The rule requires that all items of value received by the underwriter be disclosed and that total underwriting compensation be "fair and reasonable." FINRA reviews proposed underwriting terms to ensure compliance and may object to excessive compensation. Items subject to review include the spread, warrants or options received by the underwriter, rights of first refusal, non-accountable expense allowances, and any other benefits.

Regulation M

Regulation M under the Securities Exchange Act of 1934 prohibits manipulation in connection with securities offerings. Key rules include:

• Rule 101: Restricts underwriters and other distribution participants from bidding for or purchasing the offered security during the distribution period (with limited exceptions, such as stabilization)
• Rule 102: Restricts the issuer and selling security holders from bidding for or purchasing the security during the distribution
• Rule 103: Governs stabilization activities, permitting stabilizing bids at or below the offering price
• Rule 104: Addresses penalty bids and syndicate short covering
• Rule 105: Prohibits short selling a security during the restricted period prior to a public offering and then purchasing the offered shares