Best efforts underwriting

What Is Best Efforts Underwriting?

Best efforts underwriting is a contractual agreement in the realm of investment banking and corporate finance where an underwriter agrees to use their diligent efforts to sell as much of a securities offering as possible, without guaranteeing the sale of the entire issue. In this arrangement, the underwriter acts as an agent for the issuer, rather than purchasing the securities outright themselves. This type of underwriting is a critical component of capital raising, particularly for companies that are smaller, unseasoned, or conducting offerings in uncertain market conditions.¹⁸

History and Origin

The practice of underwriting securities has a long history, evolving with the complexity of financial markets. Early forms of underwriting can be traced back centuries, but the formalized role of an investment bank acting as an intermediary in public offerings developed significantly over time. While the "firm commitment" approach became a standard for larger, more established companies, best efforts underwriting emerged as a practical alternative for issuers facing higher perceived risk or less robust market demand. This method allowed companies to attempt to raise capital without requiring an underwriter to assume the full financial burden of unsold shares. Academic research highlights that best efforts offerings have served as an important financing alternative, particularly for smaller firms, within the initial public offering (IPO) market.¹⁷

Key Takeaways

• Best efforts underwriting involves an underwriter committing to sell as many shares as possible without guaranteeing the sale of the entire offering.
• The underwriter acts as an agent for the issuer, rather than a principal, reducing the underwriter's financial risk.
• This method is often used for smaller, more speculative offerings or in less favorable market conditions.
• Many best efforts agreements include "all-or-none" or "part-or-none" clauses, which dictate that the offering will be canceled and investor funds returned if a minimum sales target is not met.
• Regulatory bodies like the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) enforce strict rules for safeguarding investor funds in contingency offerings.

Interpreting Best Efforts Underwriting

In best efforts underwriting, the interpretation centers on the commitment level of the underwriter and the associated risk allocation between the underwriter and the issuer. Unlike a scenario where the underwriter guarantees the purchase of all shares, a best efforts agreement signifies that the issuer bears the risk of the offering not being fully subscribed. This means the total capital raised could be less than the target amount, or even zero if the offering includes "all-or-none" or "part-or-none" contingencies. Investors in such offerings should understand that their funds are held in an escrow account until the contingency is met, and will be promptly returned if the minimum threshold is not achieved by the specified date.¹⁵, ¹⁶ The success of a best efforts offering is thus heavily dependent on the underwriter's sales capabilities and market reception, rather than a pre-determined financial commitment.

Hypothetical Example

Consider "Quantum Leap Technologies," a burgeoning startup seeking to raise $10 million through an initial public offering to fund its expansion. Given its early stage and the speculative nature of its technology, Quantum Leap enters into a best efforts underwriting agreement with "Apex Securities," an investment bank.

The agreement specifies a "part-or-none" contingency, meaning that at least $5 million in shares must be sold for the offering to close. Apex Securities commits to using its best efforts to sell the shares at $10 per share. Apex performs its due diligence, prepares offering documents, and markets the shares to its network of potential investors.

• Step 1: Apex Securities begins marketing.
• Step 2: After several weeks, Apex has secured commitments for $6 million worth of shares.
• Step 3: Since the $5 million minimum threshold was met, the offering closes, and Quantum Leap Technologies receives the $6 million (minus Apex's fees). If Apex had only managed to sell $4 million worth of shares, falling short of the "part-or-none" condition, all investor funds would have been returned, and the offering would have been canceled.

This example illustrates how best efforts underwriting allows companies like Quantum Leap to test market demand while mitigating the underwriter's risk.

Practical Applications

Best efforts underwriting is primarily applied in situations where the issuer or the offering itself presents higher risk or uncertainty, making a firm commitment underwriting impractical or too costly.

• Small and Emerging Companies: Startups and smaller, unseasoned companies often utilize best efforts agreements for their initial public offerings or subsequent capital raises. These companies may not have the established track record or market visibility to attract a firm commitment from an investment bank.¹⁴
• Private Placements: Many private placement offerings, particularly those conducted under Regulation D of the Securities Act, are structured as best efforts offerings. This allows companies to raise capital from a limited number of investors, often accredited investors, without the extensive registration requirements of a public offering.¹², ¹³
• Less Favorable Market Conditions: In volatile or uncertain market environments, even larger companies might consider a best efforts approach to gauge investor interest without the full financial exposure of a firm commitment.
• Specific Contingency Offerings: Offerings with "all-or-none" or "part-or-none" conditions are almost exclusively best efforts arrangements. These structures assure investors that the project or company will only proceed if a minimum amount of capital is raised, protecting them from investing in underfunded ventures. FINRA's Regulatory Notice 16-08 emphasizes the importance of safeguarding investor funds in such contingency offerings, ensuring prompt refunds if the conditions are not met.¹¹

Limitations and Criticisms

Despite its utility, best efforts underwriting comes with notable limitations and criticisms, primarily stemming from the inherent uncertainty it places on the issuer. The most significant drawback is the absence of a guarantee for the amount of capital that will be raised. If the underwriter fails to sell a sufficient number of shares, the issuer may not achieve its fundraising goals, or the entire offering could be canceled, leading to wasted time and resources.¹⁰

Historical data indicates that a substantial portion of best efforts IPOs have failed to meet their minimum sales requirements and were subsequently withdrawn. For instance, a study on best efforts IPOs from 1980-1984 found that approximately one-fourth of the attempted offerings failed to close, with offerings carrying greater uncertainty about their true value experiencing higher failure rates.⁹ This highlights the issuer's considerable risk in relying solely on the underwriter's "best efforts," especially for ventures with unproven market appeal. Furthermore, while the underwriter's financial risk is limited, their reputation can be affected by failed offerings, though this may not always translate into a loss of future business, particularly for smaller issuing firms.⁸

Best Efforts Underwriting vs. Firm Commitment Underwriting

The fundamental difference between best efforts underwriting and firm commitment underwriting lies in the allocation of risk and the nature of the underwriter's obligation.

In a best efforts agreement, the underwriter simply promises to expend their greatest effort to sell the securities. They do not purchase the shares themselves, and therefore do not bear the risk of holding unsold inventory. In contrast, under a firm commitment underwriting, the underwriter buys the entire issue from the company at an agreed-upon price and then resells it to the public. This means the underwriter fully guarantees the proceeds to the issuer, assuming all the risk of any unsold shares.⁶, ⁷ Companies typically opt for best efforts when they cannot secure a firm commitment due to size, market conditions, or the speculative nature of the offering.

FAQs

What is a "contingency offering" in the context of best efforts underwriting?

A contingency offering is a type of best efforts underwriting where the sale of securities is dependent on a specific condition being met by a certain date. Common contingencies include "all-or-none" (where all shares must be sold) or "part-or-none" (where a specified minimum amount must be sold). If the condition is not met, the offering is canceled, and all investor funds are returned.⁴, ⁵

How do regulatory bodies protect investors in best efforts offerings?

Regulatory bodies like the SEC and FINRA impose strict rules on best efforts offerings, especially those with contingencies. These rules, such as SEA Rules 10b-9 and 15c2-4, require broker-dealers to safeguard investor funds received during the offering. Funds must typically be placed into a segregated bank account or an escrow account with an independent agent and returned promptly if the offering's conditions are not satisfied.³

Can best efforts underwriting be used for private placements?

Yes, best efforts underwriting is very common in private placements. Many offerings conducted under Regulation D of the Securities Act of 1933, which provide exemptions from full SEC registration, are structured as best efforts deals. This allows companies to raise capital from a smaller, often more sophisticated investor base, without the underwriter guaranteeing the sale of all securities.¹, ²