Types of Underwriting

Two basic types of underwriting are involved in a cash offer: firm commitment and best efforts.

Firm Commitment Underwriting In firm commitment underwriting, the issuer sells the entire issue to the underwriters, who then attempt to resell it. This is the most prevalent type of underwriting in the United States. This is really just a purchase-resale arrangement, and the underwriter's fee is the spread. For a new issue of seasoned equity, the underwriters can look at the market price to determine what the issue should sell for, and more than 95 percent of all such new issues are firm commitments.

If the underwriter cannot sell all of the issue at the agreed-upon offering price, it may have to lower the price on the unsold shares. Nonetheless, with firm commitment underwriting, the issuer receives the agreed-upon amount, and all the risk associated with selling the issue is transferred to the underwriter.

Because the offering price usually isn't set until the underwriters have investigated how receptive the market is to the issue, this risk is usually minimal. Also, because the offering price usually is not set until just before selling commences, the issuer doesn't know precisely what its net proceeds will be until that time.

Best Efforts Underwriting In best efforts underwriting, the underwriter is legally bound to use "best efforts" to sell the securities at the agreed-upon offering price. Beyond this, the underwriter does not guarantee any particular amount of money to the issuer. This form of underwriting has become rather uncommon in recent years; firm commitments are now the dominant form.

5Warrants are options to buy stock at a fixed price for some fixed period of time.

Ross et al.: Fundamentals I VI. Cost of Capital and I 16. Raising Capital I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Companies, 2002

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CHAPTER 16 Raising Capital 533

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