What it means
When a company floats on a stock exchange or issues new shares, a syndicate of investment banks agrees to buy the shares at a slight discount to the offer price and sell them on at the full price. The difference they keep is the gross spread, sometimes called the underwriting discount.
From the company's point of view it is simply the cost of getting the deal done. The spread compensates the banks for three distinct jobs.
They advise on structuring and pricing, they carry the risk that the shares do not sell at the agreed price, and they distribute the shares to institutional and retail buyers through their sales networks. Each of those functions has its own slice of the fee.
Those slices are the management fee, the underwriting fee and the selling concession. The management fee goes to the banks that structured and led the deal, the underwriting fee compensates syndicate members for taking on the risk of unsold shares, and the selling concession rewards whoever actually places the shares with buyers.
The selling concession is typically the largest of the three because distribution is where most of the effort sits. Size matters enormously to the percentage charged.
Smaller offerings frequently carry spreads around 7%, a figure that has become close to a convention in the smaller end of the market, while very large offerings by well-known companies may pay 2% or less because the fixed work involved does not scale with the amount raised. A company raising $1 billion is not doing ten times the work of one raising $100 million.
The gross spread is not the only cost of going public, and treating it as such understates the true bill. Legal fees, accounting and audit work, exchange listing fees, printing and investor roadshow costs all sit outside the spread and are paid separately by the issuing company.
Boards should look at total issuance costs rather than the headline underwriting percentage alone.
In practice
Real-world examples
Example 1
A family-controlled retailer floating a minority stake negotiates its gross spread down from 7% to 5.75% by running a competitive pitch among four banks. On a $160,000,000 raise, that saves the vendors $2,000,000.
Example 2
A large utility issuing $2 billion of new shares to fund grid investment pays a gross spread of just 1.8%, because the company is already well known to investors and the placement work is straightforward relative to the size.
Example 3
A biotechnology company's finance director budgets total flotation costs at 11% of gross proceeds: 7% gross spread plus roughly 4% for legal, audit, listing and roadshow expenses. The board approves the raise on that all-in basis rather than on the underwriting fee alone.
Think of it
Gross spread is like selling your house through an estate agent who buys it from you for two hundred thousand pounds and immediately sells it to a buyer for two hundred and ten thousand pounds, keeping the ten thousand pound difference as payment for their work.
Formula
Calculation
Gross Spread = (Offer Price to Investors - Price Paid to Issuer) x Number of Shares. As a percentage: Gross Spread / Total Offering Value.
A technology company floats 5,000,000 new shares at an offer price of $20 each, raising a headline total of 5,000,000 x $20 = $100,000,000. The underwriting syndicate agrees a gross spread of 7%.
Gross Spread = $100,000,000 x 7% = $7,000,000, which is $7,000,000 / 5,000,000 = $1.40 per share.
The company therefore receives $20.00 - $1.40 = $18.60 per share, giving net proceeds of $100,000,000 - $7,000,000 = $93,000,000 before legal, accounting and listing costs.
Splitting the spread the conventional way, with 20% to management, 20% to underwriting and 60% to the selling concession, gives a management fee of $7,000,000 x 20% = $1,400,000, an underwriting fee of $1,400,000, and a selling concession of $7,000,000 x 60% = $4,200,000. Per share those work out at $0.28, $0.28 and $0.84, which add back to the $1.40 total.Case study
Seen in the real world
Larkspur Robotics is a fictional company created to illustrate how the gross spread affects a real decision. Its board planned to raise $80,000,000 by selling 4,000,000 shares at $20, and the lead bank proposed a 7% spread worth $5,600,000, leaving net proceeds of $74,400,000.
The finance director pushed back, arguing that the company's order book was already familiar to the specialist funds likely to buy the stock, so the distribution effort would be lighter than the standard fee implied. After a competitive process the syndicate agreed to 5.5%, or $4,400,000, lifting net proceeds to $75,600,000. That extra $1,200,000 funded the first year of a new test facility the board had previously deferred.
The illustrative lesson is that the spread is negotiable rather than fixed, particularly where the issuer brings its own investor relationships to the table. It is also worth noting that the company still paid roughly $3,000,000 in legal, audit and listing costs on top, which never appeared in the underwriting percentage.
Watch out
Common mistakes
- Treating the gross spread as the total cost of going public. Legal, accounting, listing and marketing costs sit outside it and can add several percentage points to the true bill.
- Assuming 7% is a fixed market rate. It is a common convention for smaller deals only, and large or well-known issuers routinely pay a fraction of that.
- Thinking the fee is invoiced after the event. The spread is deducted from the proceeds at settlement, so the company simply receives less than the headline amount raised.
Questions
People also ask
Who receives the gross spread?
The underwriting syndicate, split between the lead managers, the underwriters taking placement risk and the banks that actually sell the shares to investors.
Does a higher spread mean a better outcome for the company?
Not necessarily, though a genuinely difficult deal may justify a higher fee because the banks are taking more risk and doing more distribution work.
Is the spread the same for bond issues?
The concept applies, but bond underwriting fees are usually much lower than equity spreads because the risk and distribution effort are smaller.