What Is Best Efforts Underwriting?

In capital markets, companies often require significant funding to grow, innovate, or expand operations. Raising this capital typically involves issuing securities, such as stocks or bonds, to investors. Underwriters, usually investment banks, play an intermediary role, connecting companies that need capital with investors. They assist issuers in navigating regulatory requirements and market dynamics involved in public or private offerings.

Underwriting facilitates the efficient flow of capital between issuers and the investing public. This helps ensure companies can access necessary funds while providing investors with opportunities to participate in various enterprises. The underwriter’s involvement is a standard practice that brings structure and expertise to the issuance of new securities.

Understanding Best Efforts Underwriting

Best efforts underwriting is a distinct arrangement where an underwriter commits to selling as many securities as possible for an issuer, but without guaranteeing the sale of the entire offering. The underwriter acts purely as an agent for the issuing company, not as a principal. This means the underwriter does not purchase the securities for its own account and therefore does not bear the risk of unsold shares.

This type of underwriting contrasts sharply with a “firm commitment” arrangement, where the underwriter agrees to buy all the securities from the issuer and then resells them to the public. In a firm commitment deal, the underwriter assumes the financial risk of any unsold securities. Conversely, under a best efforts agreement, the issuer retains the risk of any securities that remain unsold after the offering period.

The term “best efforts” signifies that the underwriter will make a good faith attempt to market and sell the securities, leveraging their network and expertise. However, this commitment does not obligate them to purchase any shares that fail to attract buyers. If the underwriter cannot sell all the securities, the unsold portion is simply returned to the issuer.

This arrangement is chosen when market conditions or the nature of the issuer make a firm commitment underwriting less feasible.

How Best Efforts Underwriting Functions

The practical operation of a best efforts agreement involves several key steps orchestrated by the underwriter. Initially, the underwriter assists the issuer in preparing necessary documentation, such as the registration statement and the prospectus, which provides detailed information about the company and the securities being offered. This preparation involves significant legal and financial due diligence to ensure compliance with securities regulations.

Following the preparation phase, the underwriter actively markets the securities to potential investors. This can include conducting “roadshows” to present the offering to institutional investors, organizing investor meetings, and utilizing their extensive network of brokers and clients to generate interest. The goal is to identify and secure commitments from buyers for the shares.

The underwriter’s compensation in a best efforts offering is typically commission-based, calculated on the number of shares successfully sold. This commission can vary, often ranging from 5% to 10% of the gross proceeds from the sold securities, depending on the size and perceived risk of the offering. The underwriter is paid only for the shares they manage to sell, aligning their incentive with successful placement.

If, after the specified offering period, not all securities are sold, the underwriter returns the unsold shares to the issuer. This means the issuer does not receive proceeds for those unsold securities, and the underwriter has no further obligation regarding them.

Scenarios for Best Efforts Underwriting

Best efforts underwriting is frequently chosen by companies that may find it challenging to secure a firm commitment from an underwriter. This often includes smaller, less established companies, such as startups, that are seeking to raise capital for the first time or are less known to the broader investment community. These issuers typically present a higher perceived risk to underwriters.

This type of arrangement is also common for offerings where the market demand for the securities is uncertain or expected to be limited. For instance, initial public offerings (IPOs) for highly speculative ventures or secondary offerings for companies with a volatile financial history might opt for a best efforts approach. A firm commitment might be difficult to obtain or prohibitively expensive in such situations.

Furthermore, best efforts underwriting is suitable for certain types of private placements, such as those conducted under Regulation D, where the offering is made to a limited number of sophisticated investors. In these cases, the underwriter’s role is to identify and approach suitable investors, without needing to guarantee the sale of all securities.

The flexibility of a best efforts agreement allows issuers to proceed with capital-raising efforts even when market conditions are less than ideal. The choice of best efforts underwriting reflects a balance between the issuer’s desire to raise capital and the underwriter’s willingness to take on risk. Issuers accept the possibility of not raising their target amount in exchange for the underwriter’s expertise in marketing and selling the securities.

Types of Best Efforts Agreements

Two common variations of best efforts underwriting specify conditions for the offering’s completion. One type is the “all-or-none” agreement, which stipulates that the entire offering must be sold by a certain date for the deal to proceed. If even a single security remains unsold, the entire offering is canceled, and all funds collected from investors are returned to them.

Another common variation is the “mini-max” agreement, also known as “part-or-none.” This structure requires a specified minimum number of securities to be sold for the offering to become effective. Once this minimum threshold is met, the offering can proceed, and the underwriter may continue to sell securities up to a predetermined maximum amount. If the minimum is not reached, the offering is canceled, and investor funds are returned.

For both all-or-none and mini-max offerings, investor funds are typically held in an escrow account by a third party until the specified conditions are met. This protects investors by ensuring their money is not released to the issuer unless the offering successfully closes according to the agreed terms. These conditional agreements provide a layer of investor protection while still allowing issuers to attempt to raise capital under specific parameters.