Initial Public Offerings (IPOs)
Issuing of new shares in the primary market. Usually, shares are sold through brokers on what is known as the best-efforts basis. The investment bank or broker will help in estimating or calculating the price for the shares, this is usually calculated as the Company`s value divided by the number of outstanding shares. (shares already in possession by the stockholders). Usually, the price quoted will be a little lower than the expected value of the company shares. The reason being to make sure that all can be sold. (Hull, 2018)
According to (Sherman, 1999), in the firm commitment approach to initial public offering the underwriter, which is the investment banker in our context guarantees the success of the offering process and is ready to take up any risk associated with unsold shares. The choice between the two approaches best efforts and firm commitment depends on the likelihood of risk associated with each of the methods.
Firm commitment Approach.
As explained above the company approaches an investment bank that is well-vested in the securities market to underwrite the stock. Usually, well-established and reputable investment bankers engage in firm commitment. In this approach, the bank assumes all liability or losses associated with the unsold stock. The investment banker buys the shares from the issuer at a discount which they believe they can sell at profit to potential investors. If they manage to sell the securities at a higher price the underwriter(investment banker pocket the proceeds). Even if some of the stock is not sold the underwriter is obliged to pay the agreed sum to the issuer.
Best effort Approach.
Usually practiced by an underwriter with little records of underwriting in the securities market. Remember the reputation of the underwriter is key because the issuer is after raising capital or to sell the maximum possible shares. The underwriter agrees on a fee or percentage commission on every share purchased. The underwriter is given a certain time to complete the sale or the minimum number of shares. If the period lapses before reaching the prescribed minimum. The shares are withdrawn from the market and the investors are refunded their money.
Firm commitment versus Best effort Approach
It is therefore essential to both the insurer and the underwriter to decide the best method. We can see that in the firm commitment the insurer is safe, they are entitled to their full- payment despite the success or failure of the IPO. In the best efforts, the insurer has the risk of failing to sell the minimum number of shares and will have to reimburse the subscribers. On the same note, the underwriter will have a sunk cost, advertisement and all promotion cost will be borne by them
Question:
An investment bank has been asked to underwrite an issue of 20 million shares by a company. It is trying to decide between a firm commitment where it buys the shares for$10 per share and the best effort where it charges a fee of 15 cents for each share sold. Explain the pros and cons of the two alternatives and show equations if necessary.
Solution
Firm Commitment Best efforts
$10 X 20 million =$200 million $0.15 X20 million =$3 million Possible outcomes
a) The shares are sold at $15
Profit/Loss =($15-$10) X 20 million
=$100 million
b) The shares sold at $8
($8 – $10) X 20 million
=($40 million)
Explanation: The firm commitment is profitable to the underwriter when the is a greater likelihood that the stocks can be sold at a higher price than the price being paid to the issuer. However, if the price falls down the underwriter will bear the risk. In the above example, the loss will be $40 million. To be paid to the corporation by the underwriter.
| Profits if best efforts | Profits if firm Commitment | ||
| Can sell at $15 | $3 million | $100 million | |
| Can Sell at 8 | $3 million | ($40 million) | |
| The amount of $40 million should be paid to the corporation (issuer) in case of downside risk., | |||
Bibliography
Hull, J., 2018. Risk management and financial institutions, Fifth edition. ed. Wiley, Hoboken, New Jersey