During an IPO a company hires an Investment bank to underwrite the processes. As these are newly released shares and are never traded before in the stock market it is difficult to find the correct share price hence investment banks help in these processes.
Get complete CFA Online Course by experts Click Here
The investment bank has three options of taking the IPO they are Firm Commitment, Best Efforts & All in All out. Firm commitment means the investment banks commit to buy all the shares offered by the company in an IPO and sell them in the stock market. In best efforts, the Investment bank tries to sell as many shares as possible in the IPO. All in all out the company either sells all shares in an IPO or none.
Processes of Best Efforts:
In Best Effort the underwriter gets relief from buying all the unsold shares as in the contract it is decided that it will sell as many shares as possible. The underwriter tries to sell as many shares as possible in an IPO of the company and gets commission fees in return for the service. With best efforts, the investment bank can act as an agent making its best effort to sell as many stocks as possible in an IPO. The profit earned depends on the number of bonds or shares sold and on the extent of the difference between the price of the shares were sold fr and the underwriters marked down the purchase price.
Best Efforts vs Firm Commitment:
- In Best Efforts, the underwriter is not obligated to buy all the shares of the company which are unsold in an IPO. In Firm Commitment underwriter is obligated to buy all the shares of the company and sell them in the IPO processes.
- In Best Efforts, the underwriter tries to sell as many shares as possible and don’t face any risk if some shares remain unsold. In Firm Commitment the underwrites face the risk of unsold shares as it is a loss for the underwrites as it has brought those shares from the company going public.
- In best efforts underwrites act as an agent. In Firm commitment, the underwriter cannot act as an agent.
- In best-effort underwriter earns commission fees for selling the shares in an IPO. In Firm commitment, the underwriter earns a profit by t=selling the shares at a higher price in an IPO.
Example (Real World):
In September 2015, Aperion Biologics filed an offering statement on Form 1-A with the securities and exchange commission (SEC) to sell $20 million in an IPO. The agent, WR Habrecht+ Co., employed the best effort approach to selling the Aperion shares.
As defined in the jumpstart our business startups act (JOBS), Aperion is a small company that qualifies as an emerging growth company. For the fiscal year ending Sept 30, 2015, revenue was $34,000. Considering Aperion’s small size, WR Hambrecht chose to underwrite a best-efforts offering to minimize its risk by not selling the shares. The January 2016 filing registered 3.1 million Aperion shares, and the proposed price range of $7 to $9, with the shares offered on an all-or-none basis.
Get complete FRM Online Course by experts Click Here
Hence, we can conclude that best efforts, is safer and less risker for the underwriter as he has no obligation to buy unsold shares. In Firm commitment, he has the risk of buying unsold shares and can get lost in the share price falls. In Best-Efforts the underwriter gets commission fees for helping the company sell the shares in an IPO. hence it acts as an agent.
Author – Hariharan Krishnan
About the Author – Hariharan Krishnan is currently in second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.