Best Efforts Underwriting Explained for Issuers & Investors

Key Takeaways

• Best efforts underwriting means the underwriter agrees only to try to sell securities—not to purchase them outright.
• This structure is common for higher-risk securities like IPOs or when market conditions are uncertain.
• Types of best efforts agreements include all-or-none and part-or-none offerings, with strict rules around returned funds if minimums aren’t met.
• Underwriters typically earn a flat fee and are not financially responsible for unsold shares.
• Compared to firm commitment underwriting, best efforts involves less risk for underwriters but more uncertainty for issuers.

A best-efforts offering is a contract where a securities underwriter guarantees to make their best effort in selling as many securities as possible.

What Is Best Efforts?

Acting as an agent, the underwriter of an investment bank agrees to put in their best effort in selling the initial public offering (IPO) of a business to the public. The investment bank does not participate in the purchasing of the securities and does not guarantee a price at which the securities will sell. This type of agreement is less prevalent than a firm commitment offering.

In other words, a best-efforts offering is a legal obligation between the underwriter (most likely an investment bank) and the business issuing stock, which the underwriter will put in their best effort to get the highest selling price as possible.

Best-effort arrangements are usually created in weak market conditions or with securities that seem to be higher risk, such as IPOs. Many underwriters prefer this type of agreement as it relieves them of being fully responsible for selling all of the inventory of shares that they possess.

In this type of arrangement, the underwriter is usually paid a flat fee with no incentive for commission because they are taking substantially less risk in this type of offering. The investment bank and the underwriter are simply utilized as an agent that will put forth their best effort in selling the stock.

The investment bank doesn't purchase the securities that it will sell to the public. Rather, the bank is provided with the option to buy only the number of shares that they believe they can sell. Also, the bank is usually able to cancel the offering and return the fee.

Certain conditions, such as part-or-none or all-or-none are included in the arrangement. A part-or-none offering occurs when only a specific number of securities need to be sold to achieve the goal, while an all-or-none requires that all of the shares sell in order for the deal to close.

The Financial Industry Regulatory Authority's (FINRA) SEA Rule 10b-9 insists that all capital raised must be promptly returned if the contingency offering thresholds are not achieved.

Best Efforts: How It Works

Not all securities are required to be sold in a best-effort agreement. Typically, an underwriter and issuer agree to a minimum amount of revenue, and once that threshold has been met, the underwriter is no longer liable for any of the unsold securities. For example, if Company ABC is planning on having an IPO and hires an investment bank to arrange the process, the bank's main goal is to sell as many shares as possible at the highest price.

Underwriters will typically go on road shows to pitch the IPO to investors to get an idea of what price the IPO could generate. The underwriter will then take this feedback from potential investors and communicate it to the issuer in order to create the offering price and size.

The underwriter will typically handle the physical sale of the shares in a best-effort agreement. Depending on the size of the IPO, the underwriter may form a syndicate to enlist the help from other banks to assist in the selling of the securities. This usually helps to:

• Increase the sales
• Increase the issue price
• Decrease the pressure on the underwriting bank

Regulation S-K and SEC Rule 10b-9 require that underwriters disclose all best-effort agreements in the prospectus of the IPO, and specify the amount of time the offering will be open. Also, the prospectus should contain all details regarding the underwriter's commitment to sell a certain number of shares or raise a minimum amount of revenue. As required in Rule 15c2-4, the proceeds from a best-effort IPO need to be placed into a special bank account or escrow account until the underwriter and issuer agree that all of the underwriter's prerequisites have been satisfied.

Best Efforts: Why It Matters

Best-effort agreements prevent the issuer from knowing how much capital is raised until after the offering has closed. The issuer may not know that they haven't raised the required amount of capital until after the fact. If this happens, a lot of money and time is wasted on a failed IPO.

Firm-commitment offerings are usually open less time than a best-efforts offering. Best efforts tend to allow more time for negative news to hurt the IPO and create more risks. This is why many investors and analysts consider a best-efforts offering to be considerably more risky than firm commitments.

Regulatory Compliance and Legal Considerations

Best efforts offerings are subject to federal securities laws and specific disclosure requirements. Key regulatory components include:

• SEC Rule 10b-9: Requires that any contingency offering (e.g., all-or-none) must return investor funds if the condition is not met.
• Rule 15c2-4: Mandates that underwriter proceeds must be placed in a separate escrow account until offering conditions are fulfilled.
• Regulation S-K: Requires issuers to include underwriting terms, duration of the offering, and other relevant details in the prospectus.

Failure to comply with these requirements can result in regulatory penalties and investor litigation.

Real-World Example of Best Efforts Underwriting

Suppose a small biotech firm is preparing for its IPO and hires an underwriter under a best efforts agreement. Due to the speculative nature of its products and uncertain revenue streams, the underwriter agrees to try to sell up to 1 million shares at $10 each but does not guarantee that all shares will be sold.

The underwriter markets the offering to potential investors and ultimately sells 600,000 shares. Since it was a part-or-none deal requiring a minimum of 500,000 shares sold, the offering closes successfully, and the issuer receives $6 million in proceeds.

Had the underwriter only sold 400,000 shares, the offering would have been canceled and funds returned to investors.

Advantages and Disadvantages of Best Efforts Underwriting

Advantages:

• Lower Risk for Underwriters: They are not obligated to buy unsold securities.
• Flexible Structure: Issuers can include conditions like AON or part-or-none provisions.
• Helpful in Unstable Markets: Suited for IPOs or high-risk companies with uncertain demand.

Disadvantages:

• Uncertain Capital Raised: Issuers may receive less funding than anticipated.
• Potential Deal Failure: Offerings can collapse if minimum sales aren’t met.
• Weaker Investor Confidence: Compared to firm commitment offerings, investors may view best efforts as riskier.

Comparison: Best Efforts vs. Firm Commitment Underwriting

Understanding how best efforts underwriting compares to firm commitment underwriting is crucial for both issuers and investors:

Best efforts underwriting provides less certainty to issuers but minimizes liability for underwriters, making it more appropriate in volatile or uncertain markets.

Types of Best Efforts Underwriting Agreements

Best efforts underwriting agreements may vary based on the level of commitment and structure of the deal. Common types include:

• All-or-None (AON): The entire offering must be sold for the deal to go through. If the underwriter cannot sell all the securities, the offering is canceled and any collected funds are returned to investors.
• Part-or-None: A specified minimum amount must be sold for the offering to close. If the threshold isn’t met, the deal is voided and investor funds are returned.
• Mini-Max (Minimum-Maximum): This combines elements of AON and part-or-none structures. A minimum number of shares must be sold to close the offering, but sales can continue up to a specified maximum once the minimum is met.

These structures provide some flexibility to issuers while protecting investors from incomplete or undercapitalized offerings.

Frequently Asked Questions

1. What is best efforts underwriting in simple terms?
   It’s an agreement where the underwriter agrees to do their best to sell a securities offering but does not guarantee to sell all the shares.
2. Who uses best efforts underwriting?
   Companies with higher-risk offerings or uncertain investor interest—such as startups or those launching an IPO—often use best efforts underwriting.
3. What happens if not all shares are sold?
   If it’s an all-or-none or part-or-none offering and the minimum threshold isn't met, the offering fails, and funds are returned to investors.
4. How is best efforts underwriting regulated?
   It is governed by SEC rules such as 10b-9 and 15c2-4, which ensure investor protection and transparent fund handling.
5. What is the difference between best efforts and firm commitment underwriting?
   In best efforts, the underwriter is not obligated to buy unsold shares. In firm commitment, they buy the entire offering and bear the risk of unsold inventory.

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