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Best efforts

What Is Best Efforts?

A "best efforts" offering is a type of underwriting agreement in which an investment bank acts as an agent for the issuing company and pledges to use its most diligent efforts to sell the issuer's securities to investors. Unlike other underwriting arrangements, the investment bank does not guarantee the sale of all the securities. This means the issuer bears the market risk and the risk of the offering not being fully subscribed. Best efforts offerings are a component of capital markets activities, particularly relevant for smaller or newer companies seeking to raise capital without the firm backing of a traditional underwriting syndicate.

History and Origin

The concept of investment banks facilitating the sale of securities dates back centuries, evolving significantly alongside the development of financial markets. In the United States, modern investment banking began to take shape in the 19th century, with firms helping to syndicate debt for government and railroad projects. The post-Civil War era saw a surging demand for capital, which further propelled the role of these financial intermediaries.

The "best efforts" approach emerged as a practical alternative for companies that might not attract a full firm commitment underwriting, which involves an underwriter guaranteeing the purchase of all shares. This type of arrangement became more formalized as regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), established rules governing public offerings. FINRA Rule 5110, known as the Corporate Financing Rule, for example, regulates the underwriting terms and arrangements, including compensation, for firms participating in public offerings7. These regulations ensure fairness and transparency in how investment banks engage with companies to bring their securities to market, whether through a guaranteed sale or a best efforts approach.

Key Takeaways

  • A best efforts offering is an underwriting agreement where the underwriter sells as many securities as possible without guaranteeing the sale of the entire issue.
  • The issuer retains the risk of unsold shares in a best efforts offering.
  • This method is often used by smaller companies or those with less established track records seeking to raise capital.
  • Underwriters act as agents, earning a commission on the shares they successfully sell.
  • Best efforts offerings are subject to regulatory oversight by bodies such as FINRA and the Securities and Exchange Commission (SEC).

Formula and Calculation

There is no specific formula for a "best efforts" offering itself, as it primarily defines the nature of the agreement between the issuer and the underwriter, rather than a quantifiable financial metric. However, the calculation of proceeds to the issuer and the underwriter's compensation involves straightforward arithmetic.

The total proceeds to the issuer from a best efforts offering are calculated as:

Total Proceeds=(Number of Shares Sold×Offering Price per Share)−Underwriting Fees−Expenses\text{Total Proceeds} = (\text{Number of Shares Sold} \times \text{Offering Price per Share}) - \text{Underwriting Fees} - \text{Expenses}

The underwriter's compensation, typically a percentage of the gross proceeds from the shares sold, is calculated as:

Underwriting Fees=Number of Shares Sold×Offering Price per Share×Commission Rate\text{Underwriting Fees} = \text{Number of Shares Sold} \times \text{Offering Price per Share} \times \text{Commission Rate}

Where:

  • Number of Shares Sold: The actual quantity of shares the underwriter successfully places with investors.
  • Offering Price per Share: The price at which each share is offered to the public.
  • Underwriting Fees: The compensation paid to the underwriter for their services.
  • Commission Rate: The agreed-upon percentage the underwriter receives per share sold.
  • Expenses: Other costs associated with the public offering, such as legal fees, printing, and regulatory filing fees.

Interpreting the Best Efforts

Interpreting a best efforts agreement primarily involves understanding the allocation of risk and the nature of the underwriter's role. In this arrangement, the underwriting firm is not purchasing the securities from the issuer for resale; rather, it commits to using its expertise and distribution network to sell the shares to the public. This implies that if the market demand for the securities is insufficient, not all shares may be sold, and the issuer will not receive the full anticipated capital.

This contrasts sharply with a firm commitment offering, where the underwriter guarantees to buy all the securities from the issuer, thereby assuming the risk of unsold shares. Therefore, for an issuer considering a best efforts offering, it is critical to assess the market's receptiveness to their valuation and the proposed offering price. The success of a best efforts offering heavily relies on the underwriter's ability to market the shares effectively and the underlying demand from investors.

Hypothetical Example

Imagine "GreenTech Innovations Inc.," a startup developing sustainable energy solutions, decides to go public to raise $10 million. Due to its nascent stage and the inherent market volatility, larger investment banks are hesitant to offer a firm commitment underwriting. Instead, "Venture Capital Advisors" (VCA), a smaller broker-dealer specializing in emerging companies, agrees to a "best efforts" offering.

VCA proposes to sell 1 million shares at $10 each, aiming for the $10 million target. Their commission rate is 7% of the gross proceeds, plus a reimbursement for up to $100,000 in direct expenses related to the offering.

VCA conducts its marketing and sales efforts, including investor roadshows and online campaigns. After three months, despite their best efforts, VCA only manages to sell 700,000 shares.

Here’s the breakdown:

  • Shares Offered: 1,000,000
  • Offering Price per Share: $10.00
  • Shares Sold: 700,000
  • Gross Proceeds from Sales: 700,000 shares * $10.00/share = $7,000,000
  • VCA's Underwriting Fees: $7,000,000 * 7% = $490,000
  • Reimbursable Expenses: $100,000 (assuming actual expenses were at least this much)
  • Net Proceeds to GreenTech Innovations Inc.: $7,000,000 - $490,000 - $100,000 = $6,410,000

In this hypothetical example, GreenTech Innovations Inc. only raised $6.41 million, falling short of its $10 million target. This illustrates the core characteristic of a best efforts offering: the capital raised is not guaranteed, and the risk management associated with the offering falls predominantly on the issuer.

Practical Applications

Best efforts offerings are commonly found in several areas of finance and investing:

  • Early-Stage Companies: Startups and smaller companies with limited operating history or high growth potential often use best efforts agreements because they may not meet the stringent requirements for traditional underwriting or may find the costs prohibitive. This allows them to access public markets, albeit with the inherent risk of not raising all desired capital.
  • Private Placements: While often associated with public offerings, the "best efforts" concept also applies to certain private placements where an intermediary assists in finding investors for non-registered securities without committing to purchase the entire issue.
  • Shelved Offerings: In some cases, established companies may use a best efforts basis for portions of a "shelved" offering, where they register securities that can be issued over time, depending on market conditions. This provides flexibility without the immediate commitment of a traditional underwriting.
  • Specific Securities: Certain types of securities, such as limited partnership interests or some forms of asset-backed securities, may be offered on a best efforts basis, especially if they have a niche market or unique risk profiles.
  • Regulatory Compliance: Firms involved in best efforts offerings must adhere to various regulatory requirements. For instance, FINRA Rule 5110 outlines the filing requirements and standards for underwriting compensation in public offerings, ensuring that participating firms disclose information about terms and arrangements to FINRA. 6Companies considering a public offering, regardless of the underwriting type, must navigate a complex regulatory landscape and file a registration statement with the SEC, which requires comprehensive disclosures,.5
    4

Limitations and Criticisms

Despite its utility for certain issuers, the "best efforts" model carries significant limitations and has faced criticisms:

  • Uncertainty of Funds: The most prominent drawback for the issuer is the lack of guaranteed funding. A company undertaking a best efforts offering might not raise the full amount of capital it seeks, potentially disrupting its business plans or leaving it undercapitalized. This financial uncertainty places considerable due diligence burden on the issuer to assess market demand.
  • Market Risk on Issuer: Unlike a firm commitment where the underwriter assumes market risk, the issuer bears the risk of market reception and demand in a best efforts offering. If investor interest is low, the offering may be undersubscribed or fail entirely.
  • Lower Prestige/Visibility: Best efforts offerings are often associated with smaller, less established companies, which can sometimes lead to lower market visibility or perceived prestige compared to offerings backed by a large underwriting syndicate with a firm commitment.
  • Underwriter's Motivation: While the underwriter commits to "best efforts," their financial incentive is tied only to the shares sold. Critics argue this might lead to less aggressive marketing than a firm commitment deal where the underwriter faces direct financial exposure for unsold shares. Regulatory bodies like FINRA monitor underwriting terms to prevent unfair or unreasonable arrangements.
    3* Compliance Burden Remains: Even with a best efforts approach, the issuer still faces substantial regulatory compliance requirements for a public offering, including preparing and filing detailed registration statements with the SEC,.2 1The complexity and cost of these filings can be a significant hurdle, irrespective of the underwriting type.

Best Efforts vs. Firm Commitment

The fundamental distinction between a "best efforts" offering and a "firm commitment" offering lies in the allocation of risk and the underwriter's obligation.

In a best efforts offering, the underwriter acts purely as an agent for the issuer. The underwriter agrees to use its reasonable "best efforts" to sell the securities to investors, but it does not guarantee that all the shares will be sold, nor does it purchase the shares for its own account. The issuer retains the market risk and the risk of the offering being undersubscribed or failing. The underwriter's compensation is typically a commission on the shares actually sold.

Conversely, in a firm commitment offering, the underwriter (or a syndicate of underwriters) agrees to purchase the entire issue of securities from the issuer at a set price, then resells them to the public. In this scenario, the underwriter assumes the full financial risk of any unsold shares. If the shares cannot be sold to the public at the offering price, the underwriter bears the loss. This type of arrangement provides the issuer with guaranteed proceeds, making it a more attractive option for established companies with strong market appeal. The choice between best efforts and firm commitment hinges on the issuer's financial strength, market conditions, and willingness to assume risk.

FAQs

What does "best efforts" mean in finance?

In finance, "best efforts" refers to an underwriting agreement where the investment bank, acting as an agent, agrees to use its utmost diligence to sell a company's securities to investors without guaranteeing the sale of the entire issue. The issuing company bears the risk of unsold shares.

Why would a company choose a best efforts offering?

A company, particularly a smaller or newer one, might choose a best efforts offering if it cannot secure a firm commitment from underwriters due to higher perceived risk, lack of a proven track record, or volatile market conditions. It allows them to access the capital markets without the underwriter taking on the full risk of the offering.

Are best efforts offerings common?

Yes, best efforts offerings are common, especially for smaller or emerging companies seeking to raise capital. They are a viable alternative when a firm commitment underwriting is not feasible or desirable.

What happens if not all shares are sold in a best efforts offering?

If not all shares are sold in a best efforts offering, the issuer will only receive capital for the shares that were successfully sold. The unsold shares remain with the issuer, and the company will not meet its target capital raise. This highlights the risk management aspect for the issuer.

Is a prospectus required for a best efforts offering?

Yes, for public best efforts offerings, a prospectus is generally required to be filed with the SEC. This document provides potential investors with detailed information about the company and the securities being offered, regardless of the underwriting structure.