Page 173 - Initial Public Offering - An Introduction to IPO on Wall Street

In general, underwriters will go on roadshows to promote the business of the issuer and to
decide the offering’s price and size. It is crucial to understand that the investment bank is
provided the option to buy the securities and act as brokers, as compared to an underwritten
sale, where the underwriter buys the whole issue and makes it available for purchase by the
public.

Thus, in the best effort offering, the underwriter encounters considerably less risk because
they will not experience the risk of some of the issue being unsold. For this reason,
underwriters are typically paid a flat fee without commission in a best efforts deal. If the
underwriter is not able to fulfill the sales quota, the fee payable by the issuer is usually
waived by the underwriter.

Example

ABC Company hires XYZ Investment
Bank as its underwriter. The business is
hoping to generate $500 million through
the sale of 500 million shares in an IPO.
XYZ Investment Bank observed that
demand for shares was likely to be low
because of market volatility. As a result,
ABC Company asked for a best efforts
commitment in exchange for a $20 million
fixed fee.

It was established in a roadshow that there was a demand for 150 million shares of the
business. If the minimum sales requirement is $200 million, should ABC Company make the
best efforts offering for XYZ Investment Bank?

As only 150 million shares are in demand, the revenues produced will only be $150 million.
As a result, it would not be possible for XYZ Investment Bank to meet the revenue threshold.
As they will not be able to fulfill the sales requirement to earn their fixed fee, the bank should
not perform the best effort offering for ABC Business in this scenario.

Reasons for a Best-Efforts Offering

During weak market conditions or for stocks that bear more risk, the best effort offering is
widely used. The market for securities is usually lower in such situations and it would be
risky for the underwriter to make an underwritten offer.

For instance, if the underwriter knows that there will be a low demand created by an issue,
there would be no incentive for the underwriter to give an underwriting offer to buy the
whole issue and take on the risk of not being able to sell the issue to potential buyers. Instead,
the underwriter may opt to make the best effort offering and try to sell enough shares to reach
the sales threshold required to obtain the fixed fee.

Important Additional Information on Best-Efforts

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