What it means
The agreement turns months of preparation into a binding commitment. It names the issuer and the underwriters, states how many shares or bonds are being sold, and fixes the price the underwriters will pay the issuer.
The offer price to the public is usually set at the same time, based on the order book built during marketing. Two main structures exist.
In a firm commitment agreement the underwriters buy the whole issue and take the risk of reselling it, while in a best-efforts agreement they only agree to try, and the issuer bears the risk of unsold securities. Firm commitment is the norm for large deals because issuers value certainty.
The document also contains representations and warranties, which are statements by the issuer that its financial statements, legal position and disclosures are accurate. If a statement turns out to be false, the issuer may have to indemnify (compensate) the banks.
Conditions to closing, such as no major market disruption and delivery of comfort letters from the auditors, give the banks ways to withdraw in extreme cases. Many agreements include an over-allotment option, often called a greenshoe, which lets the underwriters buy extra shares from the issuer, commonly up to 15% of the base deal, if demand is strong.
It helps the banks stabilise the share price after listing by covering any short position. For a finance professional the key numbers to check are the net price to the issuer, the underwriting discount and any expense reimbursement, because these decide how much cash the company actually receives.
A one percentage point change in the discount on a $40,000,000 deal moves $400,000 between the issuer and the banks. Lock-up provisions are another common feature.
They stop the company's directors and existing shareholders from selling their own shares for a set period after the offering, often several months, which prevents a flood of stock reaching the market just after listing. Investors and banks both see the lock-up as a sign that insiders remain committed.
In practice
Real-world examples.
Example
A fintech company agrees a firm commitment to sell 5,000,000 shares through three banks. The agreement fixes the price at $22.50 per share to the public and gives the banks a 15% over-allotment option. Those two terms together fix the cash the company receives on closing day.
Example
A property group issues $150,000,000 of notes under an agreement that includes warranties on its accounts. A month later the banks request a comfort letter from the auditors as a condition of closing.
Example
A small manufacturer on a junior market uses a best-efforts agreement to raise $8,000,000. The bank agrees to market the shares, but the company accepts that it may raise less if investors are not interested.
Formula
Calculation
Net proceeds = Shares x (Offer price - Underwriting discount per share) - Issuer expenses
A company sells 2,000,000 shares at an offer price of $20, with a 5% underwriting discount.
Discount per share = $20 x 5% = $1.00, so the price paid to the issuer is $20 - $1.00 = $19.00
Gross proceeds to the public = 2,000,000 x $20 = $40,000,000
Underwriters' compensation = 2,000,000 x $1.00 = $2,000,000
Proceeds before expenses = 2,000,000 x $19.00 = $38,000,000
If legal, audit and printing costs paid by the issuer are $1,000,000, net proceeds are $38,000,000 - $1,000,000 = $37,000,000.
If the underwriters also exercise a 15% greenshoe, they buy a further 15% x 2,000,000 = 300,000 shares at $19.00, which brings the issuer another $5,700,000 before expenses.Case study
Seen in the real world.
Copperfield Medical is an illustrative, fictional device maker that signed an underwriting agreement for 3,000,000 shares at $30. The agreement required a clean legal opinion and a comfort letter from its auditors before the closing date.
Two days before closing, the auditors identified an unrecorded $1,200,000 liability. The banks threatened to use the closing conditions to delay the deal until the accounts were corrected and the prospectus updated.
Copperfield rushed through the correction, and the deal closed a week late at a price $1 lower. The illustrative story shows why the representations and conditions in an underwriting agreement are not boilerplate: they decide who bears the cost when something is found at the last minute. After the delay, the board adopted a rule that the financial statements must be reviewed by an independent accountant before any future offering is launched.
Watch out
Common mistakes.
- Assuming every underwriting agreement guarantees that the issuer receives the full proceeds, when best-efforts deals do not.
- Focusing only on the offer price and forgetting the discount, expenses and indemnities, which decide net cash.
- Treating the representations and warranties as formalities, when a false statement can create real legal and financial liability.
Questions
People also ask.
What is the difference between firm commitment and best efforts?
In a firm commitment the underwriters buy the whole issue and carry the resale risk, whereas in best efforts they simply try to sell and the issuer keeps the risk.
What is a greenshoe in an underwriting agreement?
It is an option for the underwriters to buy extra shares, often up to 15% more, to cover over-allotments and support the price after listing.
When is the agreement signed?
Usually after marketing finishes and the price is set, just before the securities are offered and allocated to investors.
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