The importance of IPO underwriting in a successful public offering

A successful IPO provides a fair price for the company and the selling shareholders, if any; a stable or rising share price subsequent to the IPO; and a strong following of interested security analysts. Almost all IPOs are arranged through an investment banking firm (underwriter, managing underwriter). One of the functions of IPO underwriting is to underwrite your securities—that is, to buy your company’s securities from you and sell them to other syndicate members and/or the investing public. While nothing prevents you from conducting your own public offering, the use of a qualified underwriter is beneficial to ensure a successful offering.

Your initial contacts with an investment banking firm likely will be with a representative whose primary responsibility is to bring in new business for the underwriter. It is essential that you meet with and evaluate the investment banking, research and trading department personnel as part of your selection process. Further, your decision to select an underwriter should be based, in part, on the desire of the investment banking firm to develop a long-term relationship with your company. This often is demonstrated by the underwriter’s willingness to help you prepare your company for an IPO, even if the IPO is one or two years in the future.

Ideally, the selection process should begin well in advance of the proposed offering. This will allow you to assess the underwriter and how your company will work with them. Frequently, your independent accountant and SEC counsel can make introductions to several qualified underwriters with whom they have worked successfully in the past. You should talk to several underwriting firms to determine which one is right for you. However, you do not want to talk to so many underwriters that the offering is widely known. Some factors to consider include whether you need a national or regional perspective for the offering and whether the underwriter selected should have a strong retail (individual customers) or institutional capability. Bigger is not always better.

The rapport between you and the underwriter, the underwriter’s interest in you and your company and the underwriter’s ability to perform are essential to a successful relationship. In particular, you should review other IPO transactions the underwriter has completed. In addition, you should exercise caution regarding the proposed offering price per share. An underwriter who proposes to price the offering at an amount that is significantly higher than others may not be able to get the IPO completed at the quoted price or to sustain the stock price in the market following the offering. Your relationship with the underwriter will not, and should not, end when the offering is completed. You and the underwriter should be interested in a long-term relationship.

Underwriters are compensated based on commissions earned upon the successful completion of the offering. However, the selection of an underwriter should not be based solely on the commission to be paid. Instead, it should be based on other characteristics such as reputation, distribution capabilities, experience with companies of your size and industry, and the ability to sell your size of offering. The underwriter’s existing backlog of offerings and the amount of attention you will receive also should be considered. Once the underwriting is completed, your underwriter must be capable of making a market for your company’s shares and providing research and financial advice. For most companies, the optimal distribution of their shares would be to a large number of investors holding relatively small quantities of stock. This generally results in a larger trading market for your company’s securities and somewhat mitigates the large swings resulting from the selling or buying of larger blocks of stock.

In the final analysis, your company might not have the luxury of choosing from a broad range of underwriters. Just as you must decide which underwriter is right for you, the underwriter also must select the companies that most closely match its size and capabilities. Accordingly, many businesses undertaking their IPO might not be able to attract an underwriter who possesses all the qualities they desire. It takes time to get the best match available, and the process should be started early.

Types of underwriting agreements

There are generally two major types of underwritings, with many variations of each. The optimal form of underwriting is the firm underwriting commitment, under which the underwriters agree to buy all the stock being offered at the offering price. They then resell it to other syndicate members or directly to the public. The underwriter bears the financial risk if it is unable to resell all the stock in a firm underwriting commitment.

The second major type of underwriting is the best-efforts arrangement, whereby the underwriters agree to use their “best efforts” to sell your company’s securities, but do not guarantee results. If they do not sell the entire amount to the public, or the minimum amount if there is a minimum/maximum provision, they have no obligation to purchase the shares. As such, they are acting merely as your agent, and you bear the risk if shares cannot be sold or if they are sold, that the minimum proceeds might be inadequate for your needs.

The firm commitment is generally the best arrangement because it provides more assurance that your company’s stock will be sold. The next most desirable arrangement is the best efforts—all or none. Although this puts the risk of sale on you, it assures you that you will not go public unless all stock is sold and sufficient proceeds are received to meet the requirements of your business plan.

However, a word of caution: The underwriter’s “firm commitment” only becomes a commitment when the underwriting agreement is signed by both you and the managing underwriter, which is usually on the day the registration statement becomes effective. Until then, you bear the risk if shares cannot be sold due to changes in market conditions, unfavorable market response to your company or improper pricing of the shares. Accordingly, if you have completed all audit and legal requirements, SEC filing work and printing, but the response to your offering is poor, the underwriter usually will not execute the underwriting agreement, and the IPO might be abandoned—at least temporarily. The result is a costly exercise for your company in professional fees, out-of-pocket costs and time. Accordingly, it is important that you discuss candidly with the managing underwriter the likelihood that it can complete the offering at the indicated price and its experience with terminated offerings.

Letter of intent and the underwriting agreement

You will be required to sign various documents with the managing underwriter before the IPO is completed. The two most significant agreements are the letter of intent and the underwriting agreement. The letter of intent is a nonbinding agreement (except for any expense provisions), which states that you and the underwriter agree to file a registration statement for a specified number of shares within a predetermined price range. Once it is signed, work on the registration process usually begins in earnest. A letter of intent, while not committing the underwriter to sell the shares, usually prohibits you from working with another underwriter for a specific period of time.

The underwriting agreement includes the duties and responsibilities of both your company and the underwriter, including the underwriter’s obligation to purchase the shares for resale to other syndicate members or the public. This document includes various representations and warranties by both your company and the underwriters. It also contains requirements for opinions from your SEC counsel and a “comfort letter” from your registered public accounting firm, which must be received by the underwriter before its purchase of the shares. It is important for your legal counsel and accounting firm to review this document before it is finalized. It is only upon the signing of the underwriting agreement that the underwriter is obligated to purchase the shares from your company for resale. Significant costs will be incurred between the time you sign the letter of intent and the underwriting agreement. Therefore, you should ask the underwriter for a copy of its typical underwriting agreement before signing the letter of intent to assure yourself that you will be able to sign the underwriting agreement when it is required.

IPO underwriters’ compensation

Underwriters are compensated by receiving a commission based on a percentage of the gross proceeds from the offering. In most cases, this commission on IPOs ranges from 5% to 7% of the gross offering proceeds. A lesser percentage can be negotiated in certain circumstances, for example, in the case of a very large offering or where a seasoned company is undertaking its second or third offering. Underwriters often use other methods to increase their compensation, such as requiring expense reimbursements for certain costs incurred. Some underwriters require companies to reimburse them for accountable expenses up to a specific amount and for unaccountable expenses, often equal to 2% to 3% of the gross offering proceeds.

In addition, many underwriters require the registrant to sell them, at a nominal price, a warrant for the purchase of 10% of the number of shares sold in the offering at an exercise price equal to the public offering price, plus a percentage (such as 20%). This warrant is normally exercisable over a five-year period and, if exercised, results in further dilution of the existing shareholders. As a result, the company receives fewer proceeds as compared to the proceeds received when shares are sold on the open market.

One additional method of underwriters’ compensation is a requirement that you give them the right to act as the underwriter on your next public offering, with the same terms and conditions that you would be able to negotiate with other underwriters.

Although the above represent some typical underwriter compensation arrangements, the compensation is usually negotiable with the underwriter to a limited extent and can vary significantly from underwriter to underwriter.