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.

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.

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.

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