When it comes to raising capital for a company, one of the most common ways is through securities underwriting. Underwriting refers to the process of a financial institution purchasing securities from an issuer in order to sell them to investors. There are two primary types of underwriting: firm commitment underwriting and best effort agreement. So, what`s the difference between the two?

Firm commitment underwriting

Firm commitment underwriting is the most traditional and straightforward form of underwriting. In this type of underwriting, the underwriter guarantees to purchase all of the securities being offered by the issuer and assumes the financial risk if the securities cannot be sold to investors. The underwriter`s goal is to sell as many securities as possible, at the highest possible price, in order to make a profit.

In firm commitment underwriting, the underwriter typically agrees to purchase the securities at a discounted price and then resell them to investors at a higher price. The difference between the purchase price and the selling price is the underwriter`s profit. The underwriter takes on the risk that the securities will not be sold at a high enough price to cover its costs. In exchange for taking on this risk, the underwriter charges a fee, known as the underwriting spread.

Best effort agreement

Best effort agreement, on the other hand, is a less common form of underwriting where the underwriter does not guarantee to purchase all of the securities being offered by the issuer. In a best effort agreement, the underwriter agrees to use its best efforts to sell as many securities as possible, but it does not assume any financial risk if the securities cannot be sold to investors.

In a best effort agreement, the issuer retains a greater degree of control over the sale of the securities. The underwriter acts as a broker, helping to market the securities to potential investors and taking a commission on securities that are sold.

The main difference between firm commitment underwriting and best effort agreement is the level of risk the underwriter takes on. In firm commitment underwriting, the underwriter assumes financial risk and guarantees to purchase all of the securities being offered. In best effort agreement, the underwriter does not assume any financial risk and only agrees to use its best efforts to sell the securities.

In conclusion, whether a company chooses firm commitment underwriting or best effort agreement will largely depend on its financial needs and risk tolerance. While firm commitment underwriting offers a greater level of certainty and guarantees the sale of all securities, it also carries a greater level of risk for the underwriter. Best effort agreement, on the other hand, offers more control for the issuer but may result in a lower level of securities sold. As with any financial decision, it`s important to carefully consider your options and seek advice from a financial professional.