What Is an Underwriting Agreement and How Does It Work?

An underwriting agreement is a foundational contract in bringing new securities, such as stocks or bonds, to the public market. This legally binding document is between an entity issuing securities and one or more investment banks, known as underwriters. It formalizes the terms under which underwriters commit to selling the issuer’s securities to investors, facilitating capital raising for organizations.

Defining Underwriting Agreements

An underwriting agreement serves as a comprehensive contract outlining the responsibilities and obligations of both the issuer and the underwriter(s) within a public offering. This agreement establishes the framework for the sale and distribution of new securities, ensuring clarity on pricing, quantity, and the allocation of various duties.

The key parties are the issuer, the underwriter(s), and often a syndicate of underwriters. The issuer is the entity, whether a corporation or a governmental body, that creates and offers securities for sale to raise capital. Underwriters are typically investment banks that advise the issuer, structure the offering, and handle the distribution of securities to the public. They leverage their market knowledge and distribution networks to help the issuer achieve its capital-raising goals.

For larger offerings, multiple underwriters often collaborate by forming a syndicate. This syndicate shares the risks associated with the offering and pools their distribution efforts to reach a wider investor audience. The agreement provides a clear roadmap for the entire securities issuance process, from initial pricing to final distribution.

Different Types of Underwriting Commitments

Underwriting agreements vary primarily based on the level of commitment the underwriter makes to purchasing and selling the issuer’s securities, which directly influences the distribution of risk. The most prevalent form is firm commitment underwriting, where the underwriter agrees to purchase all the securities from the issuer at a predetermined price. This arrangement means the underwriter assumes the full risk of any unsold shares, as they are obligated to pay the issuer for the entire offering regardless of their success in reselling the securities to the public. The underwriter then aims to profit from the spread between the purchase price from the issuer and the higher price at which they sell the securities to investors.

In contrast, best efforts underwriting involves the underwriter acting as an agent for the issuer rather than purchasing the securities outright. Under this type of agreement, the underwriter commits only to using their “best efforts” to sell the securities to the public, without guaranteeing the sale of all shares. The issuer retains the risk of unsold securities; if the underwriter cannot find enough buyers, the offering may not be fully subscribed. This approach is often chosen for smaller or less established issuers, as it places less financial burden and risk on the underwriter.

Within best efforts underwriting, there are specific subtypes that further define the conditions of the offering. An “all-or-none” arrangement stipulates that if not all securities are sold by a specified deadline, the entire offering is canceled, and all funds collected from investors are returned. A “mini-max” agreement is similar but requires a minimum number of securities to be sold for the offering to proceed, while also setting a maximum limit on the total amount that can be sold.

Another distinct type is standby underwriting, which is commonly utilized in rights offerings. In this scenario, an underwriter agrees to purchase any shares that are not subscribed to by existing shareholders during a rights offering period. This provides assurance to the issuer that all shares will be sold, as the underwriter stands ready to acquire any remaining securities.

Standard Provisions in an Underwriting Agreement

Underwriting agreements contain numerous standard provisions that define the terms, conditions, and responsibilities governing a securities offering.

Offering Details

This provision specifies the fundamental aspects of the securities being issued, including the type of security, the total quantity, the offering price per security, and the anticipated offering date. This section sets the precise parameters for the entire transaction.

Representations and Warranties

These are crucial statements made by the issuer to the underwriter, affirming the accuracy and completeness of information provided, such as financial statements and compliance with relevant laws and regulations. These assurances are fundamental to the underwriter’s due diligence process and their decision to proceed with the offering.

Covenants

These are promises made by the issuer to the underwriter that outline specific actions the issuer will take or refrain from taking after the agreement is signed. This includes providing ongoing financial information or maintaining certain corporate conditions, ensuring continued transparency and stability throughout the offering period and beyond.

Conditions Precedent

These clauses detail the requirements that must be satisfied before the closing of the securities offering can occur. These often include obtaining necessary regulatory approvals, ensuring the accuracy of all representations and warranties up to the closing date, and delivering legal opinions from counsel. Failure to meet these conditions can lead to the termination of the agreement.

Indemnification Provisions

These outline which party is responsible for legal liabilities and damages that might arise from the offering, such as misstatements or omissions in the prospectus. Typically, the issuer agrees to indemnify the underwriter against such claims, except for those directly resulting from the underwriter’s gross negligence or willful misconduct.

Termination Clauses

These specify the conditions under which either the issuer or the underwriter can end the agreement before the offering is completed. These often include the occurrence of a material adverse change in market conditions, a significant disruption in financial markets, or a breach of the agreement by either party.

Lock-up Agreements

These provisions restrict insiders, such as company executives and major shareholders, from selling their existing shares for a specified period, typically 90 to 180 days, after the public offering. This helps prevent a sudden influx of shares that could depress the stock price shortly after the offering.

Overallotment Option (Green Shoe Option)

This grants the underwriter the right to sell up to 15% more shares than initially planned to cover oversubscriptions or to stabilize the stock price in the aftermarket. This option provides flexibility for managing demand and supporting the security’s initial trading.

Underwriting Spread or Commission

This represents the compensation earned by the underwriter for their services. This is the difference between the price the underwriter pays the issuer for the securities and the public offering price at which they sell them to investors, often ranging from 3% to 7% of the gross proceeds, depending on the offering size and risk.

The Agreement’s Function in Securities Offerings

The underwriting agreement formalizes the relationship between an issuer and its underwriters throughout the complex process of a public securities offering. It guides the transaction, ensuring parties are aligned on objectives and execution.

A primary function is to explicitly outline and allocate the various risks associated with bringing securities to market. By defining the underwriter’s commitment, the agreement clarifies who bears the financial risk of unsold securities or market volatility. This clear allocation of risk protects both the issuer and the underwriter.

The agreement also ensures compliance with applicable securities laws and regulations. It mandates that due diligence and disclosure obligations are met, which is crucial for maintaining market integrity and avoiding potential penalties from regulatory bodies.

The agreement contributes to investor protection by stipulating rigorous due diligence and disclosure requirements. This helps ensure accurate and comprehensive information is available to potential investors, enabling informed investment decisions.

Ultimately, the underwriting agreement enables capital formation in public markets. It provides a clear, legally enforceable structure for issuing and distributing new securities, allowing entities to raise necessary funds from a broad investor base. This access to capital is essential for business expansion, innovation, and overall economic growth.