Key Takeaways
- Contract between issuer and underwriter for securities sale.
- Defines risk, pricing, fees, and legal terms.
- Types include firm commitment, best efforts, all-or-none, standby.
- Underwriter earns fee by managing sale risk.
What is Underwriting Agreements?
An underwriting agreement is a formal contract between a securities issuer and underwriters, typically investment banks, that outlines the terms under which the underwriter will purchase or facilitate the sale of new securities like stocks or bonds to investors.
This agreement is crucial for capital raising events such as initial public offerings (IPOs) or bond issuances, ensuring the issuer secures funding while the underwriter manages sales risk and pricing.
Key Characteristics
Underwriting agreements have distinct features that define the roles, risks, and financial arrangements between issuers and underwriters.
- Risk Allocation: Agreements specify if the underwriter assumes full risk (firm commitment) or acts on a best efforts basis, affecting who bears unsold securities risk.
- Underwriting Fee: The underwriter earns a spread or commission, which is the difference between the purchase price from the issuer and the resale price to the public.
- Legal Clauses: Include representations, warranties, covenants, and conditions for termination such as material adverse change (MAC) clauses.
- Pricing and Quantity: Terms detail the purchase price per security and total number of shares or bonds to be issued.
- Disclosure Requirements: The issuer must provide accurate information, often documented within a prospectus to comply with securities regulations.
How It Works
Underwriting agreements begin with negotiation where the lead underwriter presents a standard form contract outlining responsibilities and risk. Once agreed, the underwriter purchases securities from the issuer or commits to sell them to the public.
The underwriter then resells the securities at a markup, managing the pricing and marketing efforts. If the agreement is a firm commitment, the underwriter guarantees the issuer a fixed amount of capital, while a best efforts agreement leaves unsold securities risk with the issuer.
This process involves due diligence, pricing strategies, and coordination with legal counsel to ensure compliance and proper disclosure as part of the offer and sale of securities.
Examples and Use Cases
Underwriting agreements are common in various sectors and financial transactions:
- Banking: Major institutions like Bank of America and JPMorgan Chase frequently act as underwriters for IPOs and bond issuances.
- Bond Funds: Fixed income funds such as Vanguard Total Bond Market ETF often invest in securities issued through underwriting agreements.
- Airlines: Companies like Delta utilize underwriting agreements when raising capital by issuing new shares or bonds.
Important Considerations
When entering an underwriting agreement, carefully evaluate the risk profile and fee structure, as these directly impact your capital raised and cost of financing. Understand the implications of clauses like material adverse change and ensure thorough disclosure to avoid legal complications.
Working with experienced underwriters and legal advisors can help tailor agreements to your company’s needs, balancing risk and ensuring compliance under securities laws governing equity shares and other instruments.
Final Words
Underwriting agreements define key responsibilities and risks between issuers and underwriters, shaping how capital is raised and priced. Review the terms carefully and consult with legal or financial advisors to ensure the agreement aligns with your funding goals and risk tolerance.
Frequently Asked Questions
An underwriting agreement is a formal contract between a company issuing securities and one or more underwriters, usually investment banks. It outlines the terms under which the underwriters purchase or facilitate the sale of new stocks or bonds to the public.
Underwriting agreements are crucial because they help companies raise funds by defining the underwriter’s role in managing sales risk, pricing, fees, and legal responsibilities. They are especially important during IPOs, bond issuances, or rights offerings.
The main types include firm commitment, best efforts, all-or-none, and standby agreements. Each varies in how risk is allocated between the issuer and underwriter, ranging from the underwriter buying the full issue to only selling as much as possible without guaranteeing full sale.
In a firm commitment agreement, the underwriter buys the entire issue from the issuer at a fixed price and resells it to the public. This guarantees the issuer will raise the intended funds, but the underwriter assumes the risk of any unsold securities.
Best efforts underwriting means the underwriter tries to sell as many securities as possible but doesn't guarantee the full amount will be sold, so the issuer bears the risk of unsold shares. Firm commitment underwriting guarantees the issuer receives full proceeds as the underwriter buys the entire issue.
Underwriting fees, or spreads, are the compensation the underwriter earns, representing the difference between the price paid to the issuer and the resale price to the public. This fee covers the risk and effort involved in selling the securities.
A standby underwriting agreement is used mainly in rights offerings, where the underwriter agrees to buy any unsubscribed shares after existing shareholders have had their chance to buy. It acts as a safety net, ensuring the issuer raises the full intended amount.
