What it means
In a share or bond issue the underwriter sits between the company raising money and the investors buying in. In a firm commitment deal the bank buys the entire issue from the company at an agreed price and then resells it, so if demand disappoints the bank is left holding stock it has already paid for.
That transfer of risk is what the issuer is really paying for. A company coming to market gets certainty about how much cash it will receive, access to the bank's institutional client list, and advice on pricing the deal so that it neither leaves money on the table nor fails to sell.
Underwriters are paid through the gross spread, the difference between the price investors pay and the price the issuer actually receives. Large deals are shared across a syndicate, with a lead bank running the order book and co-managers taking smaller allocations and correspondingly smaller slices of the fee.
Not every deal is fully underwritten. In a best efforts arrangement the bank agrees only to use reasonable endeavours to place the securities and takes no inventory risk, which is cheaper for the issuer but offers no guarantee of proceeds.
The word carries a second and older meaning in insurance, where an underwriter assesses a proposed risk and decides whether to accept it and on what terms. The common thread across both meanings is a specialist agreeing to carry a risk that somebody else wants to hand over, in return for a fee.
In practice
Real-world examples
Example 1
A software company floats 5,000,000 shares on a stock exchange. One large investment bank leads the syndicate as bookrunner, three co-managers take smaller allocations, and the group collectively guarantees the company a fixed sum regardless of how the first day of trading goes.
Example 2
A utility issues $250,000,000 of ten-year bonds through two underwriting banks at a gross spread of 0.5%, so the banks earn $1,250,000 between them. The company receives $248,750,000 and knows that figure before the bonds are placed with a single investor.
Example 3
A haulage firm applies to insure a fleet of 40 vehicles. The insurer's underwriter reviews five years of claims history, driver records and route data before quoting an annual premium of $320,000, having declined to cover two vehicles used for hazardous loads.
Think of it
An underwriter is like a cautious bouncer at an exclusive club. They check everyone carefully at the door to make sure only those who fit the rules and will not cause trouble are allowed inside.
Formula
Calculation
Gross spread per share = offer price - price paid to the issuer
Underwriting revenue = gross spread per share x shares sold
Net proceeds to issuer = (offer price x shares sold) - underwriting revenue
A company floats 5,000,000 shares at an offer price of $20.00, so gross proceeds are 5,000,000 x $20.00 = $100,000,000. The syndicate charges a gross spread of 7%, which is $20.00 x 0.07 = $1.40 per share, or 5,000,000 x $1.40 = $7,000,000 in total. The issuer therefore receives $20.00 - $1.40 = $18.60 per share, or 5,000,000 x $18.60 = $93,000,000.
If demand is strong the syndicate may exercise an over-allotment option covering a further 15% of the deal, which is 750,000 shares. Those add 750,000 x $20.00 = $15,000,000 of gross proceeds, 750,000 x $1.40 = $1,050,000 of extra fees and $15,000,000 - $1,050,000 = $13,950,000 of extra cash for the company, taking total net proceeds to $93,000,000 + $13,950,000 = $106,950,000.Case study
Seen in the real world
Verity Grid Power is an illustrative, fictional regional electricity network that needed $300,000,000 to upgrade three substations. Two banks agreed to underwrite a ten-year bond carrying a 5.4% coupon, with a gross spread of 0.6%. That produced fees of $300,000,000 x 0.006 = $1,800,000 and net proceeds of $300,000,000 - $1,800,000 = $298,200,000.
A third bank had offered to place the bonds on a best efforts basis for 0.35%, which would have cost only $1,050,000 and saved $750,000. The finance committee turned it down because the substation contracts had already been signed and a partially placed issue would have left the company short.
In this illustrative case the extra $750,000 bought certainty rather than a better price. The board treated it, quite deliberately, as an insurance premium on the funding plan rather than as an advisory fee.
Watch out
Common mistakes
- Assuming the underwriter is just a broker taking a commission, when in a firm commitment deal it actually buys the securities and carries real inventory risk.
- Believing an underwritten deal cannot fail, when banks can and do reprice, shrink or pull an offering before it prices.
- Confusing the insurance meaning with the capital markets meaning in conversation, which leads to some very confused meetings.
Questions
People also ask
Who chooses the underwriter?
The issuing company does, usually after a selection process in which competing banks pitch on valuation, distribution reach and fee level.
Does the underwriter guarantee the share price after listing?
No, the guarantee covers the proceeds at pricing rather than where the shares trade afterwards, although stabilisation activity may support the price briefly.
Can a company raise money without an underwriter?
Yes, through a direct listing, a rights issue taken up by existing holders or a private placement, though each of those shifts more risk back onto the issuer.