When a company or other organization wants to raise funds, it frequently does so by issuing and selling new securities, such as stocks or bonds. An investment bank usually helps in this process by providing expertise and customers to buy the securities. A company does not need to use an investment bank, but it usually does, because it is less costly than trying to sell securities directly to the public.
An investment bank is not a bank in the usual sense. It doesn't have checking or savings accounts, nor does it make auto or home loans. It is a bank in the general sense, in that it helps businesses, governments, and agencies to get financing from investors in a similar way that regular banks help these organizations get financing by lending money that the banks' customers have deposited in the banks' savings, checking, and money market accounts, and CDs. In other words, connecting the need for money with the source of money.
An investment bank helps an organization, which may be a company, or a government or one of its agencies, in the issuance and sale of new securities. It is usually a division of a brokerage firm, because many of their activities are related. When an organization needs funds, it will first discuss the options and possibilities with an investment banker: how much money will be needed, what type of security to sell and any special features it might have, at what price, and how much this will cost the company.
Underwriting Agreement — Firm Commitment
If the investment bank and company reach an agreement to do an underwriting—also known as a firm commitment—then the investment bank will buy the new securities for an agreed price, and resell the securities to the public at a markup, bearing all of the expenses associated with the sale. The company gets the guaranteed funds even if the investment bank does not sell all of the securities. Thus, the investment bank takes a significant risk in a firm commitment. Often, the investment bank becomes a broker-dealer, or market-maker, in the new security.
Direct responsibilities in an underwriting include registering the new securities with the Securities and Exchange Commission, setting the offering price, possibly forming and managing a syndicate to help sell the new securities, and to peg the price of the new issue by buying in the open market, if necessary.
Selecting the Right Offer Price is very Important in an Underwriting
If the offer price is too high, the investment bank will fail to sell all of the new issue (undersubscription), then it will have to hold some of the issue in inventory, hoping to sell it later. If the investment bank holds the new issue in inventory, this will tie up capital that can be used elsewhere, or, worse yet, it will have to borrow money. Furthermore, the initial customers who paid a higher price for the new issue will be disappointed that they paid a higher price, and the investment bank may lose these customers in a future offering. The bank will also probably submit a stabilizing bid until either the new issue sells out, or it ends the offering and just takes the loss.
If the offering price is too low, then the new issue will quickly sell out, and the price of the new issue will rise quickly because the supply will be limited (oversubscription), inducing the initial investors to sell for quick profits—commonly called flipping. However, the company will not reap any of this extra money, and it will be disappointed that the initial offering price was not higher. Investment banking is a very competitive business. The issuer and other companies will see this as a failure to set the best price, and may take its future business elsewhere.
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