Page 175 - Initial Public Offering - An Introduction to IPO on Wall Street

Understanding Firm Commitment

An underwriter serves as a retailer in a firm commitment and takes responsibility for any
inventory that is unsold. The dealer benefits from a predetermined difference between the
issuer's selling price and the public offering price to the public to take up this risk via a firm
commitment.

A firm commitment sales process works differently from the best-efforts and standby
commitments. An underwriter offering best-effort shares does not promise the complete sale
of an issue at a price desired by the issuer and will not take in unsold inventory.

On the other hand, the best efforts are taken one step forward by a standby commitment in
which the underwriter agrees to buy unpurchased IPO shares at the subscription price. A firm
commitment is different from these because it assumes the responsibility for the entire stock
issue compared to part of the issue in a best-efforts case and unpurchased IPO shares in the
case of a stand-by commitment.

Example

An investment bank committing underwriting an IPO is an example of firm commitment in
an initial public offering (IPO). For example, the IPO of Facebook was underwritten by
Morgan Stanley and Goldman Sachs. A firm commitment to sell the company’s stock to the
public was made by them. They shortened it at the same point and made millions in the
process.

Page 175