Page 177 - Initial Public Offering - An Introduction to IPO on Wall Street

This is a type of share sale deal in an IPO wherein, after selling the securities to the public,
the insurer agrees to buy all the shares that remain. In a standby deal, the insurer offers to buy
all outstanding shares, usually below the stock price, at the reference price.

This subcontracting system assures the issuing business that a certain sum of money will be
brought in by the IPO. When a business has given its current shareholders the right to buy
extra shares, standby insurance exists. The issuer directs the insurer to buy shares which the
issuer has not sold in conjunction with the applications for subscriptions and shareholders.

11.1.4 Best Efforts vs. Firm Commitment
In the following example, we will assume that the issue is $5 million. The underwriter is
allowed to buy the entire $5 million issue in the best effort deal. The underwriter will buy $3
million of the issue to sell to investors if only a $3 million investor demand exists for the
issue. The underwriter will leave the remaining $2 million issue unsold if the amount reaches
the sales requirement.

In a firm commitment, the underwriter will have to buy the entire $5 million issue. The
underwriter will take on the risk of not being able to sell the entire $5 million issue and losing
money in such a situation. It is necessary to remember that in the best effort offering, there is
an opportunity to buy the issue while there is a necessity to buy the issue in a firm
commitment.

11.1.5 Standby vs. Firm Commitment
In a firm commitment, the underwriting investment bank guarantees the acquisition of all the
securities sold to the public by the issuer, irrespective of whether it is willing to sell the stock
to investors. Issuing businesses favor firm commitment underwriting arrangements over
standby arrangements, and all others, as all the money is assured immediately.

Usually, an underwriter would only consent to a firm commitment if there is a great demand
for the IPO because it is the only one assuming the risk. The underwriter is forced to put their
own money at risk. It will have to work out what to do with the outstanding shares if it is
unable to sell securities to buyers; keep them and hope for demand to increase or maybe try
to offload them at a discount, taking a loss on the shares.

In a firm commitment underwriting, the underwriter would always insist on a market-out
provision that would release them from the obligation to buy all the shares in the instance of
an occurrence that diminishes the securities’ quality.

Weak market conditions are usually not among the acceptable factors, but if the market hits a
soft spot, or there are bad results of other IPOs, material changes in the company's business
are often reasons why underwriters turn to the market out provision.

11.1.6 Standby vs. Best Efforts
The underwriters would do their utmost to sell all the shares offered in the best efforts
underwriting. However, the underwriter is not obliged to buy all the shares under any
scenario. If the market for an offer is anticipated to be lackluster, this form of underwriting

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