What Is Underwriting Discount?
The underwriting discount is the difference between the price at which an investment bank purchases securities from an issuer and the higher price at which it resells those securities to the public. This discount represents the primary compensation for the underwriting syndicate, which typically consists of one or more lead investment bank firms and often a group of other financial institutions. It is a critical component of the costs associated with issuing new equity or debt in the capital markets.
History and Origin
The practice of underwriting, involving financial intermediaries assuming risk in exchange for a fee, has roots dating back centuries in various forms of commerce. In the context of public offering of securities, the modern structure of the underwriting discount largely evolved with the growth of corporate finance in the late 19th and early 20th centuries. Before significant regulatory oversight, banks often combined commercial and investment banking activities, using deposits to fund their underwriting businesses. Over time, as markets matured and regulations were introduced, the role of the underwriter became more defined, leading to standardized practices for compensation, including the underwriting discount, which emerged as the core component of their fee. The financial industry's self-regulatory body, FINRA (Financial Industry Regulatory Authority), plays a key role in reviewing underwriting terms to ensure they are "fair or reasonable" in public offerings.6
Key Takeaways
- The underwriting discount is the difference between the price underwriters pay the issuer and the price they sell to investors.
- It serves as the main form of compensation for investment banks facilitating a securities offering.
- The size of the underwriting discount typically reflects the risks involved, the complexity of the offering, and market conditions.
- Underwriting discounts are a significant direct cost for companies undertaking a public offering, often ranging from 4% to 7% of the gross proceeds.5
- Regulatory bodies like FINRA and the SEC monitor and require disclosure of underwriting compensation to ensure fairness and transparency.
Formula and Calculation
The underwriting discount is calculated as the difference between the offering price to the public and the net proceeds received by the issuer for each security.
Expressed as a formula:
Alternatively, as a percentage of the public offering price:
This discount covers the spread earned by the underwriters for their services, which include advising the issuer, marketing the offering, and assuming the risk of unsold securities.
Interpreting the Underwriting Discount
The size of the underwriting discount can provide insights into various aspects of a securities offering. A higher discount may indicate a riskier offering, a less established issuer, or a more complex deal requiring extensive effort in book-building and distribution. Conversely, a lower discount might suggest a highly sought-after offering from a well-known company, where demand is strong and the underwriters' risk is minimized. Market conditions also play a significant role; in buoyant markets, underwriting discounts might be more competitive. It is important to view the underwriting discount not just as a cost, but as compensation for the comprehensive services provided by the underwriting syndicate, including due diligence and market-making efforts post-offering.
Hypothetical Example
Suppose "InnovateTech Inc." decides to conduct an initial public offering (IPO) of 10 million shares. After discussions with its lead investment bank, the public offering price is set at $25.00 per share. The underwriting agreement specifies an underwriting discount of $1.75 per share.
Here’s how the numbers break down:
- Public Offering Price per Share: $25.00
- Underwriting Discount per Share: $1.75
- Net Proceeds per Share to InnovateTech Inc.: $25.00 - $1.75 = $23.25
For the entire offering of 10 million shares:
- Total Public Offering Value: 10,000,000 shares * $25.00/share = $250,000,000
- Total Underwriting Discount: 10,000,000 shares * $1.75/share = $17,500,000
- Total Net Proceeds to InnovateTech Inc.: 10,000,000 shares * $23.25/share = $232,500,000
In this scenario, the underwriting syndicate receives $17.5 million for their services, and InnovateTech Inc. receives $232.5 million from the sale of its shares before other offering expenses.
Practical Applications
The underwriting discount is a standard feature in various forms of financial instruments issuances. It is prominently featured in the prospectus of a new offering, often on the cover page, detailing the gross proceeds, the underwriting discount, and the net proceeds to the company or selling shareholders. F4or instance, in an initial public offering (IPO), the underwriting discount is typically the largest direct cost to the issuer. Beyond IPOs, it applies to secondary offerings, corporate bond issuances, and municipal bond sales. These fees compensate underwriters for their extensive work, including marketing the securities, coordinating with institutional investors, and assuming the risk that they might not be able to sell all the securities at the agreed-upon public offering price. Underwriting fees for IPOs in the U.S. commonly fall within the range of 4% to 7% of the gross proceeds.
3## Limitations and Criticisms
While the underwriting discount is a necessary cost for companies seeking to raise capital in public markets, it has faced scrutiny. Critics sometimes argue that the underwriting discount, particularly in middle-market IPOs, can be disproportionately high and seemingly rigid, sometimes referred to as an "IPO tax." T2his critique often suggests that despite technological advancements and increased competition, the standard fee percentages have remained static for certain types of offerings. Another limitation from the issuer's perspective is that the underwriting discount is a direct reduction in the capital received, leading to immediate dilution for existing shareholders if the offering is for new shares. Some argue that high underwriting costs can deter smaller companies from accessing public markets, favoring private capital raises instead.
Underwriting Discount vs. Flotation Cost
The underwriting discount is a significant component of what is broadly known as flotation cost. Flotation costs encompass all expenses incurred by a company when issuing new securities. While the underwriting discount specifically refers to the difference between the public offering price and the price the issuer receives (i.e., the underwriters' compensation), flotation costs are more expansive. Flotation costs also include other direct expenses such as legal fees, accounting fees, printing costs, registration fees paid to regulatory bodies like the SEC, and other administrative expenses associated with the offering. Therefore, the underwriting discount is a primary and often the largest part of the total flotation cost, but it is not the sole cost.
FAQs
Q1: Is the underwriting discount negotiable?
A1: Yes, the underwriting discount can be negotiable, though the degree of negotiability often depends on factors such as the size and type of the offering, the issuer's reputation and financial health, the prevailing market demand for the securities, and the competition among investment banks vying for the mandate.
Q2: Who pays the underwriting discount?
A2: While the underwriting discount is technically paid by the issuer (as they receive a lower price per share than what the public pays), it is effectively absorbed by the company through a reduction in the net capital raised from the securities sale.
Q3: How is the underwriting discount disclosed to investors?
A3: The underwriting discount is a mandatory disclosure in the prospectus or similar offering document. It is typically presented in a table on the cover page, showing the public offering price, the underwriting discount (per share and in total), and the net proceeds to the issuer. Regulatory bodies require this transparency to inform potential investors of the costs associated with the offering.1