Best Effort Underwriting is a securities underwriting process where the underwriter commits to using their best efforts to sell as much of the issued securities as possible. However, it does not guarantee the sale of the entire amount of securities. The issuer shoulders the risk of unsold securities.
Overview
Definition
In a Best Effort Underwriting agreement, the underwriter agrees to act as an agent to sell the securities on behalf of the issuer but does not purchase the securities themselves. The underwriter does not promise that the entire issue will be sold but will strive to sell as much of it as possible.
Key Features
- Commitment Level: The underwriter commits only to making their best effort, rather than a firm commitment to sell the entire issue.
- Risk Distribution: The risk of unsold securities remains with the issuer, not the underwriter.
- Fees and Compensation: The underwriter typically earns a commission based on the amount of securities actually sold.
Types of Underwriting
Firm Commitment Underwriting
In contrast to Best Effort Underwriting, Firm Commitment Underwriting involves the underwriter purchasing the entire issue of securities from the issuer and then reselling them to the public. The underwriter bears the risk if the securities cannot be sold at the desired price.
Standby Underwriting
Similar to Firm Commitment Underwriting, but typically used in rights offerings. The underwriter agrees to purchase any unsubscribed shares, thus ensuring that the issuer raises the required capital.
Special Considerations
Market Conditions
The effectiveness of Best Effort Underwriting can be significantly influenced by market conditions. In a bearish or volatile market, selling the entire issue might be challenging, leading to unsold securities.
Issuer’s Reputation
The reputation and creditworthiness of the issuer can impact the success of the underwriting. High-risk issuers may find it more difficult to sell their issues on a best-effort basis.
Example
Company XYZ decides to issue 1 million shares to raise capital for expansion. They enter into a Best Effort Underwriting agreement with Underwriter ABC. Underwriter ABC agrees to sell as many shares as possible but does not commit to selling all 1 million shares. If only 700,000 shares are sold, Company XYZ is left with 300,000 unsold shares.
Historical Context
Best Effort Underwriting has been a common practice in financial markets, offering issuers a flexible and less costly alternative to Firm Commitment Underwriting. Its usage tends to increase during periods of market instability, where the risk of unsold securities is higher.
Applicability and Usage
Small and Medium Enterprises (SMEs)
Best Effort Underwriting is often employed by small and medium-sized enterprises (SMEs) that may not have the leverage to negotiate Firm Commitment Underwriting deals with underwriters.
Initial Public Offerings (IPOs)
It may also be used in IPOs where market reception is uncertain, and the issuer does not want to incur the higher costs associated with guaranteed underwriting.
Comparisons
Best Effort vs. Firm Commitment
| Feature | Best Effort Underwriting | Firm Commitment Underwriting |
|---|---|---|
| Risk | Issuer | Underwriter |
| Commitment | Sell as much as possible | Purchase entire issue |
| Cost | Generally lower | Higher due to risk assumption |
Best Effort vs. Standby Underwriting
| Feature | Best Effort Underwriting | Standby Underwriting |
|---|---|---|
| Securities Type | General issuance | Rights offering |
| Underwriter’s Risk | Lower | Higher |
Related Terms
- Underwriting: The process by which an underwriter evaluates and assumes the risk of issuing new securities.
- Initial Public Offering (IPO): The first sale of a company’s shares to the public.
- Securities: Financial instruments that represent an ownership position in a publicly-traded corporation.
FAQs
What are the advantages of Best Effort Underwriting?
Why might a company choose Best Effort Underwriting over Firm Commitment Underwriting?
What is the role of the underwriter in Best Effort Underwriting?
References
- Investopedia, “Best Effort Underwriting,” link
- Securities and Exchange Commission (SEC) guidelines, link
Summary
Best Effort Underwriting provides a flexible and often less costly method for issuers to distribute their securities in the market. While the underwriter commits to selling as many securities as possible, the issuer retains the risk of any unsold portion. This type of underwriting is beneficial in volatile markets and for issuers with uncertain market reception. Understanding the key features, applicability, and related terms can help issuers and investors make informed decisions regarding their participation in such offerings.
