An underwriting agreement is a foundational contract between an underwriting syndicate of investment bankers and the issuer of a new securities offering. This agreement stipulates the terms and conditions under which the underwriting syndicate will purchase and resell the new issue of securities to the public or private investors.
Key Elements of an Underwriting Agreement
- Parties Involved: The main parties are the issuer (a company seeking to raise capital) and the underwriters (investment banks and financial institutions).
- Terms and Conditions: Includes pricing, proceeds distribution, underwriter’s fees, and obligations.
- Firm Commitment vs. Best Efforts: Types of underwriting and the level of risk taken by the underwriters.
Types of Underwriting Agreements
Firm Commitment Underwriting
In a firm commitment underwriting, the underwriter purchases all the securities from the issuer and sells them to the public at an agreed price. The underwriter assumes the risk of not being able to sell the entire issue at the specified offering price.
Best Efforts Underwriting
In best efforts underwriting, the underwriter agrees to sell as much of the issue as possible but does not guarantee the entire issue will be sold. The issuer bears the risk of an incomplete offering.
All-or-None Underwriting
This agreement stipulates that if the entire issue cannot be sold at the offering price, the deal is canceled. This removes financial loss risk for both the issuer and the underwriters.
Standby Underwriting
Commonly used in rights offerings, the underwriter agrees to purchase any shares not taken up by existing shareholders.
Applications and Importance
Capital Raising
Underwriting agreements are crucial for companies looking to raise funds for expansion, operations, or other financial needs by issuing new securities.
Risk Management
These agreements provide a structured way to distribute financial risk between the issuer and the underwriters.
Market Confidence
A strong underwriting agreement brings confidence to potential investors by ensuring that a reputable financial institution is involved in the securities issuance process.
Historical Context
The practice of underwriting dates back to the 17th century when it was developed by Edward Lloyd’s coffee house, which later became Lloyd’s of London. Since then, the role of underwriters has expanded and become a cornerstone of modern financial markets.
Examples and Case Studies
Initial Public Offerings (IPOs)
One notable example is the IPO of Facebook in 2012, where multiple underwriters were involved in one of the largest technology offerings in history. The underwriting syndicate played a significant role in stabilizing the stock price during its initial trading days.
Rights Offerings
A case of standby underwriting can be observed in the 2014 rights offering of RadioShack, where Standard General provided a standby commitment to purchase unsubscribed shares.
Related Terms
- Syndicate: A temporary group of investment banks and brokers who come together to handle a large securities offering.
- Prospectus: A formal legal document that provides details about an investment offering for sale to the public.
- Shelf Registration: A procedure that allows an issuer to register a new issue of securities without having to sell the entire issue at once.
Frequently Asked Questions
What is the main purpose of an underwriting agreement?
The primary purpose is to set the terms and conditions under which the underwriting syndicate will purchase and distribute a new issue of securities.
Who are the main parties in an underwriting agreement?
The issuer (the company seeking to raise capital) and the underwriters (investment banks and financial institutions).
What are the risks involved in underwriting?
The primary risk for underwriters is the inability to sell the entire issue at the desired price. For issuers, it includes the risk of not raising the intended capital if the issue is undersubscribed.
References
- Fabozzi, Frank J., et al., “Foundations of Financial Markets and Institutions,” Pearson, 2010.
- Ross, Stephen A., et al., “Corporate Finance,” McGraw-Hill, 2016.
- “Securities Act of 1933.” U.S. Securities and Exchange Commission, www.sec.gov.
Summary
Understanding underwriting agreements is vital for companies and investors involved in the issuance and purchase of new securities. By clearly defining roles, risks, and responsibilities, these agreements play an essential role in the financial ecosystem, facilitating capital formation while managing associated risks.
