What it means
When a company sells new shares or bonds through investment banks, the banks buy them from the issuer at a discount and then resell them to investors at the full offering price. The gap between the two prices is the discount spread, often called the underwriting discount or gross spread.
It is the main source of income for the banks on the deal. The spread usually covers three things: the fee for managing the deal, the fee for underwriting the risk that the securities will not sell, and the selling concession paid to the firms that actually place the securities with investors.
Spreads tend to be higher on smaller and riskier offerings, where more work and more risk are involved, and lower on large, simple deals. For the issuer, the discount spread is a direct cost of raising money, and it reduces the proceeds.
A company that wants to raise $100,000,000 must sell more securities, or accept a lower net amount, depending on the size of the spread. Along with legal and filing costs, it forms part of the total cost of the offering.
The same words are sometimes used in a second sense, as the extra margin added to a benchmark rate to produce the rate used to discount future cash flows. That use appears in valuation work, where a riskier business is discounted at a higher rate.
The two meanings are linked by the idea that a bigger risk needs a bigger gap. The nuance for readers is that a lower spread is not automatically better.
A cheaper bank may have a weaker network of buyers, which can leave the issuer with a lower offering price or an unsold balance, so the true cost depends on how well the deal is executed.
In practice
Real-world examples.
Example
A small technology company floats shares on a stock exchange for the first time. The underwriters charge a spread of 7% of the offering price. The chief financial officer builds this cost into the plan for how much money the business will have after the deal.
Example
A large corporation issues $1,000,000,000 of bonds with a spread of 0.45%, which is $4,500,000. Because the deal is large and the company well known, the banks accept a thin margin. The treasury team negotiates the figure among several competing banks.
Example
A start-up founder compares two offers from banks for her company's share sale. One bank asks for a spread of 6% and the other 8%, but the second has a bigger network of institutional buyers. She weighs the extra cost of $2 per $100 against the risk of an unsuccessful sale.
Formula
Calculation
Discount spread (%) = (offering price - price paid to issuer) / offering price x 100
A company sells 5,000,000 shares to the public at $20.00 each. The underwriters pay the company $18.60 per share. The spread per share is $20.00 - $18.60 = $1.40, which is $1.40 / $20.00 = 7%. Across all shares, the banks earn 5,000,000 x $1.40 = $7,000,000, and the company receives 5,000,000 x $18.60 = $93,000,000 rather than the $100,000,000 paid by the public.Case study
Seen in the real world.
Summit Biologics is an illustrative, fictional drug developer that planned to raise $60,000,000 in a share offering. The lead bank proposed a spread of 7%, or $4,200,000, and the board asked whether this could be reduced.
After inviting two other banks to bid, the finance team obtained a counterproposal at 6%, or $3,600,000. The lead bank matched it, but only after reducing the number of investor meetings it would arrange on the road show.
The company chose the lower spread, saving $600,000, but the offering priced slightly under the target range and raised $58,000,000 gross. The illustrative lesson is that the price of the issue and the spread both matter, and a small saving on the second can be erased by the first.
Watch out
Common mistakes.
- Treating the spread as the whole cost of an offering, when legal, accounting, filing and marketing costs come on top.
- Choosing the lowest spread without considering the bank's ability to find buyers and support the price.
- Confusing the discount spread with the bid-ask spread in trading, which is a different cost paid by investors in the market.
Questions
People also ask.
Who receives the discount spread?
The underwriting banks and the selling group, who share it according to their roles in managing, underwriting and selling the deal.
Is the spread always a fixed percentage?
No. It varies with the size, risk and type of offering, and it is negotiated between the issuer and the banks.
Does the spread differ between shares and bonds?
Yes. Share offerings, especially first-time ones, usually carry higher spreads than bond offerings from established companies.
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