Standby underwriting is a financial mechanism in which underwriters pledge to purchase any shares of a new issue that remain unsubscribed by the public or existing shareholders. This guarantee ensures that the issuing company will raise a predetermined amount of capital even if the public does not fully subscribe to the share offering.
Key Components of Standby Underwriting
The Underwriting Agreement
- Standby Commitment: The core agreement where underwriters agree to buy all unsold shares.
- Firm Commitment: Often used interchangeably but typically implies underwriters commit to buying all shares upfront.
Underwriters
- Financial entities like investment banks taking on the risk of unsold shares.
- Charged with the responsibility of marketing and selling the shares.
Issuing Company
- The organization that is offering new shares to raise capital.
- Benefits by having the assurance of fully raising the needed funds.
Types of Underwriting
Firm Commitment Underwriting
The underwriter buys all offered shares outright and sells them to the public, absorbing risk but potentially earning a profit from fee spreads.
Best Efforts Underwriting
Underwriters agree to sell as many shares as possible but are not obligated to buy any unsold shares, thus sharing the risk with the issuing company.
Standby Underwriting
Underwriters only buy any remaining unsubscribed shares, ensuring full subscription even if public interest falls short.
Example of Standby Underwriting
An issuing company, ABC Corp., wants to raise $100 million by issuing new shares. It offers these to the public and current shareholders but has a standby underwriting agreement with XYZ Investment Bank. If only $80 million worth of shares are subscribed, XYZ is obligated to purchase the remaining $20 million.
Historical Context
Standby underwriting gained popularity in the 20th century as a way for companies to minimize risk while raising capital. By the 1980s, it had become a standardized practice in equity markets around the world.
Applicability and Usage
This method is widely used for:
- Initial Public Offerings (IPOs): Ensures the success of the offering.
- Secondary Offerings: Guarantees existing shareholders are complemented by underwriters’ purchases, raising the targeted capital.
Comparisons
- Standby vs. Firm Commitment Underwriting: Firm commitment involves outright purchase, while standby only involves unsold shares.
- Standby vs. Best Efforts Underwriting: Best efforts do not involve a guarantee to purchase unsold shares.
Related Terms
- Prospectus: A document detailing the investment offering to prospective investors.
- Subscription Rights: Options given to existing shareholders to buy additional shares at a discount.
FAQs
What risks do underwriters take in standby underwriting?
How do companies benefit from standby underwriting?
Are fees higher for standby underwriting compared to other methods?
References
- Ross, Stephen A., et al. “Corporate Finance,” McGraw-Hill Education.
- “Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions,” Joshua Rosenbaum, Joshua Pearl.
Summary
Standby underwriting plays a crucial role in equity financing by ensuring companies meet their capital-raising goals regardless of subscription levels. It involves a safety net provided by underwriters who commit to buying any unsold shares, contrasting with the outright purchase seen in firm commitment underwriting and the non-guaranteed sale effort in best efforts underwriting. This financial instrument underscores the importance of underwriters in stabilizing and facilitating capital markets.
