UNDERWRITING (SECURITIES)

Underwriting involves the orderly process of security registration for the financial sourcing of a public offering through the purchase of securities for resale to the public. The underwriting may be a firm commitment to purchase the entire amount of the company's securities regardless of the ability to resell them. The underwriting of such a low-priced initial public offering (IPO) and other less-well-known stock (e.g., over-the-counter stock) may be done on a best-efforts basis where the underwriter acts only as an agent and accepts no financial liabilities.

A successful underwriting not only sells the securities, but does so at a fair price. In addition, underwriters maintain a stable, liquid aftermarket for the trading of securities.

Until the 1950s, underwriting was the only function performed by a number of specialty houses. Thereafter, underwriters merged their talents with retail and institutional sales in order to bolster their sagging bottom lines. Today there is little distinction between wholesale underwriting, which serves institutional clients including broker-dealers, and retail underwriting, which sells directly to individual investors.

Most underwriting in the 1990s was handled by investment banks and brokerage firms. In 1996 the Federal Reserve Board lifted the revenue limit on securities underwriting by commercial banks and their subsidiaries from 10 to 25 percent. Although the ruling represented another falling barrier between investment banking and commercial banking, it was expected to have little effect on the underwriting industry.

Large underwriting firms assist the largest corporations with secondary offerings and maintain a financial advisory role for the long term. As full-service houses, large firms need to handle IPOs in excess of $15 million for the fees to be profitable.

Medium-size underwriting firms generally serve regional interests and handle offerings within the $5 to $15 million range. Although established companies, they lack the full range of services and number of personnel dedicated to underwriting and distribution. These firms are not likely to maintain a financial advisory capacity to their clients.

There are few remaining small underwriting firms. Some handle only small offerings called "penny stocks." Others specialize in a particular segment of the market. Offerings are usually under $7 million.

LETTER OF INTENT

A letter of intent (LOI) is an agreement to proceed with the registration of securities with the Securities and Exchange Commission (SEC). The contents of the LOI state, as clearly as possible, the duties and obligations of the parties.

A nonbinding letter of intent requires a good-faith deposit from the company to demonstrate its financial capacity to complete the costly and cumbersome process of going public. In a binding LOI the entrepreneur is responsible for payment of certain costs whether or not the securities are actually issued.

LOIs contain an adverse-change clause, allowing the underwriter to pull out if there are material adverse changes in the financial position of the company or in business conditions.

UNDERWRITING AGREEMENT

The underwriting agreement finalizes the terms of the underwriting contract, except for the final price of the security to be offered and the amount of the security to be offered. The parties usually sign this agreement a day or two before the actual public offering.

For a firm commitment, the underwriting may include a "green shoe" provision, which is an allotment option of up to 15 percent of additional stock for the account of the underwriter. When a public offering goes particularly well, the underwriter executes the green shoe to increase the amount of securities for sale.

Underwriting on a best-efforts basis uses a number of variable options to conclude the offering. An all-or-none offering will be canceled if all the securities are not sold. A mini-max offering establishes acceptable upper and lower ranges.

UNDERWRITING COSTS

Underwriters are paid commissions, securities, or through a combination of fees and securities. In a firm commitment the price underwriters pay the company for the securities is expected to be less than the price offered to the public. This "underwriter's spread" compensates the underwriter for conducting the offering. The spread averages 10 percent or less and is dependent on the anticipated complexity and size of the offering. The maximum spread allowed by the National Association of Securities Dealers (NASD) is 10 percent.

There are certain "nonaccountable expenses" that cannot be construed as an integral part of the offering, but which were necessitated by the preliminary steps to bring the company to the registration process. The NASD is the only exchange that requires an accounting of these expenses.

UNDERWRITING SYNDICATES

When offerings are too large for one firm to digest, the lead underwriter forms a temporary syndicate of other underwriters and broker-dealers to assist with the initial fund raising and the distribution of the securities. The participation of other firms in the underwriting minimizes the risks for all participants.

The originator of the offering is the managing underwriter and acts as the financial adviser to the syndicate. The managing underwriter keeps 30 percent of the underwriting spread, allowing 70 percent for the other participants.

At the time of the offering, a rectangular advertisement with a bold outline, called a "tombstone ad," appears in the business pages announcing the offering. It names the issues, describes the security offered, and lists all the participating firms.