Best Efforts Offering: Everything You Need to Know
A best-efforts offering is a contract where a securities underwriter guarantees to make their best effort in selling as many securities as possible.4 min read
2. Best Efforts: How It Works
3. Best Efforts: Why It Matters
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.
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