Best Efforts (IPO Underwriting) – Explained

Cite this article as:"Best Efforts (IPO Underwriting) – Explained," in The Business Professor, updated February 27, 2019, last accessed May 30, 2020, https://thebusinessprofessor.com/lesson/best-efforts-in-underwriting-definition/.

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Best Efforts (Bank Underwriting) Defined

During an initial public offering, the offering company hires an investment bank (or other financial institution) to underwrite the process. The underwriter attempts to get commitments from its investor connections to purchase the shares being offered in the IPO. As compensation, the underwriter receives a block of the shares that it can hold or sell for a profit.

Best Efforts underwriting is when an underwriter agrees to give his or her highest personal effort to sell as much as possible of the IPO shares. This can be compared to firm commitment underwriting where the underwriter guarantees sale of the block of shares or it will purchase any unsold shares.

A Little More on What is Best Efforts in Underwriting

Best efforts agreements gives relief to underwriters from the obligation to purchase any of the shares they cannot sell. In a best-efforts contract, the underwriter refrains from promising the entire IPO issue will get sold. Underwriters receive a set amount for their services in a best-efforts agreement, so not only is the underwriter’s risk limited but also the underwriter’s potential for profit.

With best-effort shares, the investment bank can act as an agent making its best effort to sell the stock issue. The investment bank does not buy all of the public securities. Instead, the bank can decide to buy only the share adequate to satisfy client demand. Also, the bank has the option to cancel the whole stock issue and lose out on receiving a fee.

There can sometimes be conditions included in best-efforts offerings, such as part-or-none and all-or-none. All-or-none shares must be sold completely to close the deal. Whereas, part-or-none offerings, require only a designated number of securities to qualify for deal closure.

Public offerings can get handled in different ways by issuers and underwriters. In opposition to a best-efforts agreement, a firm commitment, also known as a bought deal, means the underwriter is required to purchase full shares offering. The profit earned depends on the number of bonds or shares sold and on the extent of the difference between the price the shares were sold for and the underwriter’s marked down purchase price.

References for Underwriter Best Efforts

Academic Research on Best Efforts by Underwriters

  • How investment bankers determine the offer price and allocation of new issues, Benveniste, L. M., & Spindt, P. A. (1989). Journal of financial Economics, 24(2), 343-361. Benveniste and Spindt examine how investment bankers rely on the signs of interest from their investor clients to price and appropriate new stock issues. In an attempt to get differently informed investors to divulge what they know to the underwriter, the authors use an auction. The investigation reveals how the priority of distribution will be given to the typical investors of an underwriter, and the new issues will be cheapened. The authors also discover the type of underwriting agreement preferred is influenced by the bias of the underwriter to presell a share offering and the issuer’s greed to keep maximum proceeds.
  • Capital raising, underwriting and the certification hypothesis, Booth, J. R., & Smith II, R. L. (1986). Journal of Financial Economics, 15(1-2), 261-281. The authors form a theory of the underwriter’s role in approving issues prices that are risky to demonstrate unfavorable inside information. Literature that deals with the use of “reputational capital” as assurance of product quality served as the inspiration and foundation of the authors’ theory. A cost/benefit example of underwriting is used to create a valid association with the choice of the negotiated versus competitive underwriting, announcement effects, underpricing of issues and degree of compensation for the underwriter as service of information that is specific to a firm.
  • The choice between firm-commitment and bestefforts offering methods in IPOs: The effect of unsuccessful offers, Dunbar, C. G. (1998). Journal of Financial Intermediation, 7(1), 60-90. Dunbar acknowledges how prior research challenges the use of the best-efforts offering procedures for initial public offerings —  considering firm-commitment offerings prove to have lessened direct issue costs. This paper tries to justify decisions of best-efforts methods by bringing attention to an indirect offering cost, which is the chance of an offering being unsuccessful.

 

  • Investment banking and the capital acquisition process, Smith Jr, C. W. (1986). Journal of Financial Economics, 15(1-2), 3-29. This paper examines the evidence and theory of the procedure by which companies increase equity and debt capital and the related influence it has on the prices of investment instruments. The results of associated transactions are used to assess the hypotheses about price patterns of stocks with security offerings announcements. Smith investigates several agreement options, such as firm commitment or best-efforts contracts, rights or underwritten offers, traditional or shelf registration, and competitive or negotiated bid.
  • A simple test of Baron’s model of IPO underpricing, Muscarella, C. J., & Vetsuypens, M. R. (1989). Journal of financial Economics, 24(1), 125-135. Baron’s model of underpricing for initial public offerings (IPOs) depends on information lacking balance between underwriters and issuers, and forecasts lower offer prices would abound when there is uneven information. This paper challenges that model. After assessing 38 IPOs of investments that went public during the years between 1970 and 1987 and also took part in the distributing of their securities, the authors find that oppositional to the Baron’s model, these offerings were statistically further underpriced than other initial public offerings.
  • Investment banking: An economic analysis of optimal underwriting contracts, Mandelker, G., & Raviv, A. (1977). The Journal of Finance, 32(3), 683-694. The authors discuss how there has been little analysis done which address the offering of a firm’s shares to the public for the first time.  There have been a few studies done which explain underwriters’ behavior, but no attention has been given to what is the best agreement to have between the underwriter and issuing firm. This paper presents a model to fill the gap between an underwriter’s compensation and the significant cost to the issuer.
  • The costs of going public, Ritter, J. R. (1987). Journal of Financial Economics, 19(2), 269-281. This paper shows evidence of how direct expenses for firm commitment offers and best efforts offers carry the same weight but underpricing is significantly greater for best efforts offers. Despite their higher total costs, this paper explains why some firms still decide to use best efforts offers.
  • Evaluating the costs of raising capital through an initial public offering, Aggarwal, R., & Rivoli, P. (1991). Journal of Business Venturing, 6(5), 351-361.  The main suggestion of this paper is to show how expensive it is for entrepreneurs to attempt a public offering prematurely. An insignificant issuer with a small capital demand and poor income history will be at considerable cost damage compared to better-established firms. The authors recommend that a firm have a advantageous operating income and capital requirements of a minimum of $10 million before attempting a public offering.
  • Why new issues are underpriced, Rock, K. (1986). Journal of financial economics, 15(1-2), 187-212. This paper demonstrates an underpricing model for initial public offerings. The presentation depends on the presence of a collection of investors with superior information compared to that of all other investors and the firm. If new offerings get priced at an anticipated value, this group of investors crowds out the other investors when good offering come and withdraw from the market at offers of unsatisfactory issues. The offering firm must set the shares at a discounted price to ensure investors without superior information buy the issue.
  • A reexamination of the costs of firm commitment and best efforts IPOs, Chua, L. (1995). Financial Review, 30(2), 337-365. This paper explains why on average best efforts initial public offerings cost more to issue than their counterparts, firm commitment IPOs. The author examines underpricing and underwriter compensation as two necessary costs of going public. The model shows underpricing, and underwriter compensation is higher for firms that use best efforts agreements.
  • A model of the demand for investment banking advising and distribution services for new issues, Baron, D. P. (1982). The Journal of Finance, 37(4), 955-976. This paper explains a theory of the need for investment banking distribution and advising services for when the issuer is less informed than the investment banker and the distribution effort by the bank cannot be observed by the issuer. The author characterizes the best agreement for when the better-informed banker is given the responsibility of the offer price decision so that the moral hazard problems and adverse selection caused by unbalanced information gets dealt with as well as the observability problem

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