When a young company decides to sell stock in an initial public offering (IPO), it contacts an investment bank to manage the process. This is the team of underwriters who will help determine the price of the stock, describe and market it to prospective investors, document its financials, submit the required legal documents, and, finally, launch the IPO on a stock exchange.

Key Takeaways

  • In a bought deal, the underwriter buys all of the available shares for resale to its clients.
  • In a best-effort deal, the underwriter does not take responsibility for the sale of all of the shares and takes a flat fee for its services.
  • An IPO may involve several underwriters, with one taking the lead role in the preparation and launch of the shares.

The underwriter may or may not make guarantees concerning the successful sale of all shares made available in the IPO.

Understanding the Underwriter's Role

Every deal varies, particularly in the amount of risk that the underwriter agrees to take on and how the underwriter will be compensated. The two most common types of underwriting are bought deals and best effort deals.

  • In a bought deal, the underwriter purchases the entire IPO issue and then resells it to its clients, who may be primarily big institutional investors. The underwriter's compensation is the difference between the price the underwriter pays for the shares and the price it gets when it resells them. In this case, the underwriters bear the entire risk of selling the stock issue. They want to find buyers for the entire new issue┬árather than sitting on unsold shares.
  • In a best-effort deal, the underwriter may not purchase any of the IPO shares. It only makes a guarantee that it will make its "best efforts" to sell the issue to the investing public at the best price possible. Unlike a bought deal, there is no consequence for the underwriter if the entire issue is not sold. It is the issuing company that will be stuck with any unsold shares. Because there is less risk involved, the underwriter's gains are limited even if the issue sells well.┬áIn this case, the underwriter is compensated with a flat fee.

Less commonly, there is the "all or none" agreement. The company and its underwriter agree that the IPO will be canceled if all shares are not sold.

Who the Underwriters Are

The underwriters for IPOs are some of the biggest global names in banking and investing. They include Credit Suisse, JPMorgan, and Merrill Lynch, to name a few.

An IPO often involves more than one underwriter, with one lead underwriter in the most prominent role. That is the "bookrunner." The other underwriters become "co-managers" with smaller shares of responsibility for the success of the IPO and smaller percentages of the proceeds.