Key Takeaways

  • Best efforts underwriting places the sales risk on the issuing company, while underwriters agree only to try their hardest to sell the securities.
  • Unlike firm commitments, underwriters do not guarantee the sale of the full issue; unsold securities are returned to the issuer.
  • Common variations include all-or-none, part-or-none, and mini-maxi agreements, each setting conditions on how many securities must be sold for the deal to go forward.
  • Best efforts underwriting is more common in smaller or riskier offerings, where demand is uncertain.
  • Advantages include lower risk for underwriters and flexibility for issuers; disadvantages include less certainty of capital raised and potential reputational issues if the offering fails.

A best efforts underwriting agreement is a contractual arrangement, used largely in high-risk securities sales, wherein the underwriter is promising to make their best effort (hence the name) to sell as much of the security offering as they can. A best effort underwriting agreement then ensures that the underwriter is not held responsible for those securities which they cannot sell, as they are not making a promise to sell an entire IPO’s issue.

It is worth noting, however, that while the best effort underwriting agreement protects the underwriter’s risk, it also limits their profits, as they are being paid a flat rate for their work, rather than a percentage of sales, or some other payment structure.

Best Efforts Compared to Firm Commitment

There are different ways in which an underwriter or issuer can handle the initial public offerings, also known as an IPO. Some key factors with a best efforts offering include:

  • An investment bank is generally acting as the underwriter, thus promising to make their best efforts to sell the stock issues.
  • The bank is not purchasing all of the securities and then turning around and selling them; rather, the bank can purchase only those shares which they are confident they can sell.
  • Best efforts offerings can contain one of two conditions: the all-or-none condition which means the bank must sell all of the securities they bought, in order for the deal to be complete, or the part-or-none condition which means that only a pre-determined number of securities need to be sold by the bank for the obligation to have been met.
  • The bank can ultimately choose to forfeit their fee and cancel their issue, essentially returning them back to the company that is going public.
  • The bank, in being the underwriter, oversees the actual sales of the shares.
  • The bank determines the price of the issued shares they are selling.

Ultimately, as the underwriter, it is the bank's responsibility to get the best price possible for the issued shares, and to sell as many as possible, thus making their best effort. It is worth noting that if the bank is committed to selling a pre-determined number of issued shares, that information must be disclosed to potential buyers.

In addition to the best effort offerings, initial public offerings can also be made via what is called firm commitments, or a bought deal. Some key points of a firm commitment include:

  • The bank (aka the underwriter) purchases the entire issue of shares.
  • The profit earned by the underwriter is based upon the differential of the price at which they bought the shares and what they ultimately sold them for.
  • As the underwriter has purchased the entire issue and determined the price at which they will be sold, the issuer (the company that is going public), knows upfront, how much money they will be making. This makes it the most desirable offering, from the standpoint of the company.
  • Firm commitment offerings are generally only done in situations where the investment bank is quite confident of their ability to sell the issue, based upon the company’s reputation and public interest in their stocks.

Types of Best Efforts Underwriting

Best efforts underwriting can take several distinct forms, depending on how much risk the underwriter is willing to assume:

  • All-or-None (AON): The offering succeeds only if all securities are sold. If the full amount is not sold, the deal is canceled, and investor funds are returned.
  • Part-or-None: The agreement requires that a pre-determined minimum number of securities be sold. If that threshold is met, the offering goes forward; if not, it is canceled.
  • Mini-Maxi Agreement: A hybrid approach where a minimum number of securities must be sold to close the deal, but sales can continue up to a maximum level. Funds are usually held in escrow until the minimum is reached.

These structures are often used by smaller companies or in riskier offerings, where demand is less predictable.

Market Out Clause

In the case of firm commitments, the investment bank will probably insist upon having what is called a market out clause, as the underwriter is taking on a significant amount of potential risk, if they cannot sell the issue. The market out clause provides an out for the underwriter, relieving them of the obligation to sell the entire issue, should something occur that negatively impacts the value of the issued stock or the public’s interest in purchasing that company’s stock. For example, if the CEO is publically accused of sexual misconduct by multiple people and subsequently arrested, people may no longer be interested in investing in that company, making the issue much harder to sell.

It is worth noting that a downturn in the market, itself, is not considered reason for the market out clause, despite the name.

Advantages and Disadvantages of Best Efforts Underwriting

Advantages for issuers:

  • Provides flexibility for companies with uncertain demand.
  • Reduces underwriting fees compared to firm commitment agreements.
  • Can make securities offerings possible for smaller or emerging businesses.

Advantages for underwriters:

  • Lower risk since they are not obligated to purchase unsold securities.
  • Opportunity to build relationships with issuers while limiting financial exposure.

Disadvantages for issuers:

  • No guarantee that the entire issue will be sold, reducing certainty of capital raised.
  • Potential reputational harm if the offering is undersubscribed.

Disadvantages for investors:

  • May indicate higher risk since underwriters are unwilling to assume full responsibility.
  • Possible delays in accessing funds if the offering fails and money must be returned.

Additional Information

Some additional information to know about best efforts underwriting agreements includes defining the mini-maxi agreement, which means that a certain number of the securities need to be sold before the agreement is considered to be in effect. Until the underwriting agreement has been completed, the monies earned from the sales of the securities are held in escrow. Should, for some reason, that minimum number of securities not be sold, the offering is canceled, and anyone who had purchased shares has their money returned to them.

When Best Efforts Underwriting Is Used

Best efforts underwriting is generally used when:

  • The issuing company is relatively new or has a limited track record.
  • The securities market is volatile or uncertain.
  • The issuer is offering a smaller or niche security where investor interest is less predictable.
  • The issuer wants to test market demand without committing to a full firm commitment offering.

This structure is particularly common in initial public offerings (IPOs) of smaller firms or private placements, where risk is higher and investor appetite may be difficult to gauge.

Frequently Asked Questions

  1. What does best efforts underwriting mean in simple terms?
    It means underwriters agree to try to sell as many securities as possible but do not guarantee that the full offering will be sold.
  2. How is best efforts underwriting different from a firm commitment?
    In a firm commitment, the underwriter buys all the securities and takes on the risk. In best efforts underwriting, unsold securities are returned to the issuer.
  3. What are the main types of best efforts underwriting?
    They include all-or-none, part-or-none, and mini-maxi agreements, each setting conditions on how many securities must be sold.
  4. Who usually uses best efforts underwriting?
    It is most often used by smaller, newer, or riskier companies where market demand is uncertain.
  5. What are the risks for issuers in best efforts underwriting?
    Issuers face uncertainty because they may not raise the full amount of capital they need, and a failed offering can affect their reputation.

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