Underwriter: Definition, Types & Selection

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson, we will review how different types of underwriting work in investment security issues and explain how companies might choose which method to pursue.

Underwriters

Steve's e-commerce business has been really taking off lately. His company is looking at going public and selling shares of stock to raise capital to fund continued growth. To make the deal happen, Steve will need to understand the general concept of underwriting and how to choose among different types of underwriting agreements. Let's look in on Steve's research into underwriting.

The company wants to raise funds through selling equity, but it is by no means an expert in financial matters such as creating stock. This is where the underwriter comes in. An underwriter is an investment bank that will develop, market, and sell the shares of stock in Steve's company. In consultation with Steve, the underwriter will determine the price of the shares and then purchase those shares for resale to individual and institutional investors.

Underwriting Types

The exact method of how the underwriting resale agreement occurs takes the form of one of three major types. When the underwriter takes on Steve's company as a client, the two can decide which type is most appropriate based on each party's preferences and the amount of risk involved. The underwriter may offer a firm commitment or best effort bid, but could also propose a Dutch auction.

A firm commitment is a guarantee made by the underwriter to Steve that the underwriter will purchase all unsold shares at the public market price. The underwriter carries the risk that not all shares can be sold at or above the desired price. A best effort commitment is less restrictive on the underwriter; any unsold shares go back to Steve's company, which means Steve receives less money from the sale.

In a Dutch auction system, the investors determine the price of the stock by placing a bid for a certain number of shares at a specific price. Once all bids have been submitted, the highest bidders are allotted shares until all shares have been accounted for. However, the price paid for each share by the investors is set at the lowest winning bid price.

Choosing the Best Option

So which underwriting option is most appropriate for Steve to choose? That decision depends entirely upon Steve's own preferences; there isn't a one-size-fits-all answer.

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