What is a Firm Commitment?
A firm commitment has three general meanings in finance, but is most known as an underwriter's agreement to assume all inventory risk and purchase all securities for an initial public offering (IPO) directly from the issuer for sale to the public. It is also known as "firm commitment underwriting" or "bought deal." The term also refers to a lending institution's promise to enter into a loan agreement with a borrower within a certain period. A third application of the firm commitment term is for accounting and reporting of derivatives that are used for hedging purposes.
- A firm commitment generally refers to an underwriter's agreement to assume all inventory risk and purchase all securities for an IPO directly from issuers for public sale.
- Other applications of firm commitment pertain to loans and derivatives. In the former, a lender promises a borrower that the amount of loan will be available for borrowing when required.
- A firm commitment is used in accounting for derivatives, as defined in the Financial Accounting Standard Board (FASB).
Understanding Firm Commitment
In a firm commitment, an underwriter acts as a dealer and assumes responsibility for any unsold inventory. For taking on this risk through a firm commitment, the dealer profits from a negotiated spread between the purchase price from the issuer and the public offering price to the public. A firm commitment sale method contrasts with the best efforts and standby commitment basis. An underwriter selling securities on best efforts does not guarantee the full sale of an issue at the issuer's desired price and will not take in unsold inventory.
A standby commitment takes best efforts one step further whereby the underwriter agrees to purchase unsold IPO shares at the subscription price. The fee for standby commitment underwriting will be higher because the underwriter is exposed to the risk that the price it must pay for unsold shares will be at a premium to the going market price, due to weaker-than-anticipated demand.
Other Examples of a Firm Commitment
The two other common applications of a firm commitment are for loans and derivatives. As an example for the first case, when a borrower seeks certainty that it will have a large term loan for planned capital expenditure, it can obtain a firm commitment from a lender for the amount so that it may proceed.
For derivatives, a firm commitment is a concept described in the Financial Accounting Standard Board (FASB) Statement No. 133: "For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged."
Examples of Firm Commitment
An example of a firm commitment for a loan is when a financing firm or a bank commits to provide a loan for construction of a real estate property. For example, a local bank may commit to provide the necessary funds in order to build a mall in the neighborhood.
An example of a firm commitment in an IPO is when an investment bank commits to underwriting an IPO. For example, Goldman Sachs and Morgan Stanley underwrote Facebook's IPO. They made a firm commitment to sell Facebook's stock to the public. At the same time, they shorted it and made millions in the process.