What it means
When a company sells new shares through a rights issue, it first offers them to current shareholders at a set price. Some shareholders will take up their rights and others will not, so the company cannot be sure all the shares will be sold.
A standby underwriter agrees in advance to buy whatever is left over. The firm commitment gives the company certainty.
Management can plan a purchase, repay debt or fund a project knowing the money will arrive, and the bank carries the risk that the shares may not sell. Because it is taking a risk, the bank charges a fee, often a percentage of the total amount raised.
The bank's decision rests on pricing and market conditions. If the offer price is set at a deep discount to the current market price, shareholders are likely to subscribe, and the underwriter faces little risk of being left with shares.
If the discount is small or the market falls during the offer period, more shares may go unsold, and the bank may end up owning them. Banks often reduce their own exposure through sub-underwriting, in which they pass part of the commitment to other investors in exchange for part of the fee.
They may also include conditions in the agreement that allow them to withdraw if there is a major market shock or a serious change in the company's business. Companies should read these conditions closely, because they limit the certainty they are paying for.
The nuance is the difference between standby and firm commitment underwriting. In a firm commitment, the bank buys all the shares up front and resells them to investors, while in standby underwriting the bank buys only the unsubscribed portion after shareholders have had their chance.
Standby underwriting is therefore especially linked to rights issues in markets where existing shareholders have pre-emption rights. From a finance perspective, the fee is a cost of raising capital that reduces the net proceeds.
It is normally deducted from the share premium rather than expensed, but the treatment depends on accounting rules. A treasurer should compare the fee with the risk of an unsuccessful offer before deciding whether the cost is worthwhile.
In practice
Real-world examples.
Example
A mid-sized manufacturer needs $50 million to fund a new plant and offers shares to existing holders. It hires a bank as standby underwriter for a 2% fee. When only 85% of the shares are taken up, the bank buys the rest and the plant is funded on time.
Example
A property company announces a rights issue after a fall in its share price. Because the market is nervous, it pays a higher fee for standby underwriting. The company decides the extra cost is worth the assurance of full funding.
Example
A bank syndicates its standby commitment to a group of institutional investors. Each takes a share of the risk and fee. If the offer is undersubscribed, the burden is spread rather than falling on a single institution.
Formula
Calculation
Underwriting fee = Total amount raised x Fee rate
Shares taken by the underwriter = Shares offered - Shares subscribed by investors
Suppose a company offers 10,000,000 new shares at $5 each, raising $50,000,000. The standby underwriter charges 2%, so the fee is 50,000,000 x 0.02 = $1,000,000. If shareholders take up 85% of the shares, the unsubscribed amount is 10,000,000 x 0.15 = 1,500,000 shares. The underwriter buys these at $5, which costs 1,500,000 x 5 = $7,500,000. The company still receives the full $50,000,000 before the fee, so its net proceeds are 50,000,000 - 1,000,000 = $49,000,000.Case study
Seen in the real world.
Redwater Pharma is a fictional company that decided to raise $80 million through a rights issue to fund a clinical trial. This illustrative company engaged Alder Hill Securities, also fictional, as standby underwriter for a fee of 2.5%. This is a fictional scenario, not a real transaction.
Shortly before the offer closed, the market fell and only 70% of the shares were taken up by shareholders. Alder Hill bought the remaining 30%, worth $24 million, and later sold most of them back into the market. Redwater received the full amount it needed and started its trial on schedule, paying fees of $2 million.
Watch out
Common mistakes.
- Assuming the underwriter guarantees the share price. It guarantees only that the unsold shares will be bought at the offer price.
- Ignoring the withdrawal conditions in the agreement. A serious market shock or change in the company's situation may let the bank step back.
- Forgetting the fee when estimating net proceeds. The fee is deducted from the amount raised, reducing the cash the company keeps.
Questions
People also ask.
How is standby underwriting different from firm commitment underwriting?
In standby, the bank buys only the shares left unsold after existing shareholders decide, while in firm commitment the bank buys the whole issue and resells it.
When is standby underwriting used?
It is common in rights issues where existing shareholders get the first right to buy new shares.
Who bears the risk if the offer fails?
The underwriter bears the risk of unsold shares, which is why it charges a fee and may sub-underwrite part of its commitment.
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