Ch. 6: Security Offerings 245
Ta b l e 1
(Continued)Best effort. Investment banks do not underwrite these security issues, instead they only guarantee to do their
best to sell/market the issue. If less than a fixed percentage of an issue is sold, the entire issue is usually
cancelled
DRIPS. Dividend reinvestment plans allow shareholders to buy more shares in lieu of receiving cash
dividends. The shares may be sold at a small discount.
Sealed bid auction. This is a traditional method of selling IPOs. Typically a fixed number of shares are sold
on a specific date, where the rules of the auction are publicly announced considerably in advance of the
auction date. Sealed bids can generally be submitted over a specified period of time for a specific number of
shares. The auction can be fixed price so that all accepted bids are paid the same purchase price (Dutch
auction), or it can be a discriminatory auction where each accepted bid pays the bid price (Boston auction). In
a nondiscriminatory auction, investors bid for parts of an issue at their bid price. Bids are ordered and a stop
out price is determined where demand equals shares offered. All shares are sold at that price to those
investors bidding at the stop-out price or higher. In a discriminatory auction, all offers at or above the
stop-out price are accepted, but each investor pays the price they bid. Prior to the auction rules are announced
concerning the bidding process, determination of the bidder purchase price and share allocation process.
There are also often minimum bid price requirements. Other more complicated rules are also possible and are
typically used in privatizations
with the pricing meeting and expires at the end of the offer period. Since the typical
(successful) offering is fully sold out over a couple of days, the effective firm commit-
ment guarantee period is also typically short.
The following summarizes key aspects and terminology associated with the firm com-
mitment underwriting process.
Board of directors approval. Approval is necessary before an offering can occur and it
is also necessary to get prior shareholder authorization of any shares that will be issued,
though most companies typically have shareholders authorize large numbers of shares
far in advance of their possible use.
Choice of lead underwriters. Competing underwriters make presentations to the is-
suer, though many publicly listed issuers have long standing investment banking and
commercial banking relationships with one or more potential underwriters.
Advisory role of underwriters. Lead underwriters advise the issuer on the security’s
price, the timing of the offering, the size of the offering, desirable and undesirable offer-
ing characteristics, road show mechanics and meeting various regulatory requirements.
Syndicate formation. Lead (and co-lead) underwriters often line up other banks to
help underwrite and distribute shares. Syndicate members sign legal contracts to under-
write or distribute a certain number of shares in return for underwriting and distribution
fees. Lead underwriters tend to take the largest portion of the underwriting risk. In most
underwriting contracts, all banks share in any loses associated with unsold shares that
are later resold in the secondary market.