Firm commitment: Meaning, Criticisms & Real-World Uses

What Is Firm Commitment?

A firm commitment is an underwriting arrangement in investment banking where an underwriter agrees to purchase an entire issue of securities from an issuing company and then resell them to the public. This means the underwriter assumes the full risk of not being able to sell all the securities. In essence, the underwriter guarantees the issuing company that the total amount of capital sought will be raised, regardless of whether all the shares or bonds are successfully sold to investors. This type of arrangement is commonly used for initial public offerings (IPOs) and other large public offerings, particularly when the issuer desires certainty regarding the funds raised.

History and Origin

The concept of firm commitment underwriting evolved alongside the development of modern capital markets and the need for companies to raise substantial capital from a broad investor base. Historically, early forms of securities distribution were often less formal. However, as financial markets grew more complex and the scale of offerings increased, the role of an intermediary became critical. The legal and regulatory framework surrounding securities offerings, particularly in the United States, greatly influenced the formalization of firm commitment underwriting.

A significant development was the passage of the Glass-Steagall Act in 1933. This legislation, enacted during the Great Depression, aimed to separate commercial banking from investment banking activities, including securities underwriting, to reduce speculative risks within the banking system.¹⁰,⁹ While later modified, this act contributed to the specialization of financial institutions in either deposit-taking or securities underwriting, solidifying the role of dedicated investment banks in managing public offerings under a firm commitment.

Key Takeaways

A firm commitment is an underwriting agreement where the underwriter guarantees the sale of an entire securities issue.
The underwriter purchases the securities from the issuer and bears the risk of unsold shares.
This method provides certainty of capital raising for the issuing company.
It is prevalent in major public offerings like initial public offerings (IPOs).
Underwriters perform extensive due diligence before agreeing to a firm commitment.

Formula and Calculation

While there isn't a direct "formula" for a firm commitment itself, the financial calculations involved typically revolve around the gross proceeds to the issuer, the underwriting spread, and the net proceeds.

The gross proceeds are the total amount raised from investors if all securities are sold at the public offering price.
The underwriting spread (or discount) is the difference between the public offering price and the price the underwriter pays to the issuer. This spread represents the underwriter's compensation for assuming the risk and performing the distribution.
The net proceeds are the funds the issuing company receives after deducting the underwriting spread and other offering expenses.

These are related by:

\text{Net Proceeds} = (\text{Public Offering Price} \times \text{Number of Securities Offered}) - \text{Underwriting Spread} - \text{Other Expenses}

Alternatively:

\text{Net Proceeds} = (\text{Price to Issuer} \times \text{Number of Securities Offered}) - \text{Other Expenses}

Here:

Public Offering Price = The price at which the securities are sold to the public.
Number of Securities Offered = The total number of shares or debt securities being issued.
Underwriting Spread = The compensation to the underwriter(s) per security, multiplied by the number of securities.
Other Expenses = Legal, accounting, printing, and regulatory fees.
Price to Issuer = The price per security that the issuer receives from the underwriter after the spread.

Interpreting the Firm Commitment

A firm commitment underwriting signals a strong level of confidence from the underwriter in the success of the public offering. Because the underwriter is putting its own capital at risk by purchasing the entire issue, it implies that the underwriter has thoroughly evaluated the issuing company's financial health, market conditions, and the demand for the securities.

For the issuing company, securing a firm commitment means certainty of funding. They know precisely how much capital they will raise, which is crucial for business planning and investment. For investors, the presence of a reputable underwriter engaging in a firm commitment can be seen as an endorsement, suggesting that the offering has undergone rigorous due diligence and has a reasonable chance of being well-received by the market. This structure is typically reserved for companies and offerings that meet stringent criteria, including a solid financial track record and a clear market demand for their equity or debt.

Hypothetical Example

Imagine "TechInnovate Inc.," a rapidly growing software company, decides to go public to fund its expansion. They need to raise $100 million. TechInnovate approaches "Global Securities Bank," a large investment bank, to act as their underwriter.

After extensive analysis and risk assessment, Global Securities Bank agrees to a firm commitment underwriting for TechInnovate's initial public offering. The agreement states that Global Securities Bank will purchase all 10 million shares offered at $9.50 per share, with a public offering price of $10.00 per share. This means Global Securities Bank commits to paying TechInnovate $95 million (10 million shares * $9.50/share).

Global Securities Bank then works to sell these shares to institutional and retail investors at $10.00 per share. The $0.50 per share difference ($10.00 - $9.50) constitutes the underwriting spread, which is the bank's compensation. Even if Global Securities Bank only manages to sell 9 million shares to the public, TechInnovate Inc. still receives its guaranteed $95 million, as the bank bears the risk of the unsold 1 million shares.

Practical Applications

Firm commitment underwriting is foundational to how companies raise significant capital through public markets.

Initial Public Offerings (IPOs): The most common application, where private companies transition to public ownership. Underwriters guarantee the sale of newly issued shares, providing vital capital to the company. Global IPO activity is closely watched as an indicator of market health, with firms like Deloitte providing regular reviews of trends and rankings.⁸,⁷
Follow-on Offerings: Existing public companies may issue additional equity or debt securities to raise more capital for various purposes like acquisitions or expansion. A firm commitment ensures these funds are secured.
Mergers and Acquisitions Financing: Companies undertaking large M&A deals often rely on firm commitment underwriting to secure the necessary funds, ensuring they can complete the transaction.
Municipal Bond Offerings: While often associated with equity, firm commitment is also used in the issuance of municipal bonds, where investment banks guarantee the sale of bonds issued by state and local governments.
Regulatory Framework: The Securities and Exchange Commission (SEC) regulates public offerings in the U.S., requiring companies to file a registration statement and for underwriters to perform substantial due diligence. This process reinforces the commitment required by underwriters.⁶,⁵

Limitations and Criticisms

While beneficial for issuers, firm commitment underwriting has certain limitations and criticisms. The primary drawback for the underwriter is the significant market risk it assumes. If market conditions deteriorate after the underwriter commits to purchasing the shares but before they are all resold, the underwriter could incur substantial losses on the unsold portion. This risk incentivizes underwriters to conduct thorough due diligence and price the offering carefully.

For the issuing company, the cost of a firm commitment underwriting can be higher compared to other arrangements, as the underwriting spread reflects the risk assumed by the underwriter. There is also the potential for perceived conflicts of interest, as the underwriter has a strong incentive to sell all the securities quickly, which some critics argue could, in extreme cases, lead to less rigorous vetting or aggressive pricing. However, regulatory bodies like the SEC mandate comprehensive disclosure and emphasize the importance of due diligence from all parties involved in a public offering to protect investors and maintain market integrity.⁴,³,²,¹

Firm Commitment vs. Best Efforts

The main distinction between a firm commitment and a best efforts underwriting lies in who bears the risk of unsold securities.

Feature	Firm Commitment	Best Efforts
Risk Assumption	Underwriter assumes the risk of unsold shares.	Issuer retains the risk of unsold shares.
Guarantee	Underwriter guarantees the sale of the entire issue.	Underwriter acts as an agent, trying to sell, but does not guarantee.
Proceeds Certainty	Issuer is assured of a specific amount of net proceeds.	Proceeds are uncertain, dependent on actual sales.
Cost to Issuer	Generally higher underwriting fees.	Generally lower underwriting fees.
Suitability	Preferred for established companies, large offerings.	Often used by smaller, newer companies, or riskier offerings.

In a firm commitment, the underwriter effectively buys the securities from the issuer and then resells them. In a best efforts arrangement, the underwriter (or underwriting syndicate) acts as an agent, attempting to sell the securities to investors without guaranteeing that all will be sold. The issuer only receives funds for the shares or bonds actually sold.

FAQs

What does "firm commitment" mean in finance?

In finance, a firm commitment refers to an agreement in which an investment bank, acting as an underwriter, guarantees to purchase an entire new issue of securities from a company. This means the underwriter takes on the financial risk of selling those securities to the public.

Why do companies choose firm commitment underwriting?

Companies typically choose firm commitment underwriting when they require certainty regarding the amount of capital they will raise from a public offering. This guarantee allows them to plan their use of funds without worrying about a shortfall if not all securities are sold.

What is the underwriter's role in a firm commitment?

The underwriter's role in a firm commitment is to purchase the entire issue of securities from the issuing company and then resell them to investors. They bear the financial risk if they cannot sell all the securities at the agreed-upon public offering price. This role also involves extensive due diligence, marketing, and distribution.