The underwriters make their money by selling the new securities at a markup from what they paid for it, known as the underwriting discount, or underwriting spread. The underwriting discount is set by bidding and negotiation, but is influenced by the size of the new issue, whether it is stocks or bonds, and the perceived difficulty of selling the new issue, with more speculative issues requiring a larger underwriting spread for the increased risk. The flotation costs of the new issues, which is the total cost of bringing the new securities to market, also includes legal, accounting, and other expenses borne by the issuer in addition to the underwriting discount. Flotation costs are generally a greater percentage of the total sale of the new securities for small issues than for larger issues, greater for stocks than for bonds. The underwriting spread may vary from about 1% for investment-grade bonds to almost 25% for stocks of a small company.
As additional compensation, the underwriting firm may also get rights to buy additional securities at a specified price, or receive a membership on the board of directors of the issuing company. The underwriting firm frequently becomes a market maker in the new security, keeping an inventory and providing a firm bid and offer price for the new security to provide a secondary market so that investors can buy or sell the new securities after the primary sale. Providing liquidity for investors increases the value of the primary offering, since few investors would buy the new security if they couldn't sell it at will.
Syndication — Enlisting Other Investment Banks to Sell the New Securities
Sometimes the investment bank will enlist the help of other investment banks to sell the securities, forming a underwriting syndicate. The investment bank, which could be multiple firms that the company selected, is called the originating house (aka syndicate manager, managing underwriter), which selects the members of the syndicate and determines how many shares each will get, and manages the overall process. The underwriting manager determines, along with the issuer, the offering price and the time of the offering, and controls all advertising for the new issue. The managing underwriter not only handles the federal registration, and responds to any deficiency letters from the SEC, but, since state security laws (aka Blue Sky laws) require that the new issue must be registered in each state in which it is offered, the manager also ensures that the security has been Blue Skyed.
The members sign an Agreement Among Underwriters (AAU), which stipulates, among other things, the management fee, and that they will represent the issuer. Also, the percentage of each underwriter's allotment of the new issue is stipulated. There may be an overallotment provision (aka green shoe, because this provision was 1st used in an underwriting for the Green Shoe Company) that will allow the underwriters to get more shares at the original price if the issue turns out to be oversubscribed.
Each member of the syndicate must also sign an Underwriting Agreement (UA) which stipulates the relationship of the syndicate members and the issuer, including their rights, obligations, terms, and conditions, and that the issuer is required to sell and the syndicate members are required to purchase a specified number of shares. This agreement is signed when the registration of the new securities becomes effective.
There are 2 types of obligations concerning the purchase of the new issue by the syndicate members. The most common type—the divided account, or Western account—requires that the syndicate member sells its allotted shares of the new issue, but it is not obligated to sell the unsold shares of other members. The undivided account (aka Eastern account) requires that each underwriting member to buy not only his own allotted shares, but also the same percentage of unsold shares of other members as the member's allotment percentage.
Example — Western and Eastern Accounts:
5 members of the syndicate are each allotted 20% of a new issue of $100,000,000 of securities. All but $5,000,000 has been sold. If the members are bound by an Eastern account, then each member will be required to buy 20%, or $1,000,000, of the unsold shares. If, however, they agreed to a Western account, then no member has to buy the unsold shares of any other member.
In addition, each member of the syndicate, including the originating investment bank may have selling groups (also called selling syndicate), consisting of other investment bankers, dealers, and brokers, that may also sell to investors. Members of the selling group, which can number in the hundreds for some issues, sign a Dealer Agreement (aka Selling Agreement) that stipulates the terms of the relationship, including the commission (also called selling concession), the date of termination—typically 30 days—and whether the selling groups have to buy unsold shares.
The main advantage of syndication is that it reduces risk by sharing it among the syndicate members, and each syndicate member and their selling groups have their own customers to whom they can sell the new issues, so it reduces the amount that any one brokerage would have to sell, making it more likely all of the new issue would be sold.
A typical compensation arrangement for a syndicate is the originating house gets a small percentage of the underwriting spread of the entire issue; the other members of the syndicate get a percentage of all issues sold by them or their selling groups; and the selling groups get a percentage of what they sell. Below is a typical compensation schedule for a new security priced at $20 per share:
As additional compensation, the underwriting firm may also get rights to buy additional securities at a specified price, or receive a membership on the board of directors of the issuing company. The underwriting firm frequently becomes a market maker in the new security, keeping an inventory and providing a firm bid and offer price for the new security to provide a secondary market so that investors can buy or sell the new securities after the primary sale. Providing liquidity for investors increases the value of the primary offering, since few investors would buy the new security if they couldn't sell it at will.
Syndication — Enlisting Other Investment Banks to Sell the New Securities
Sometimes the investment bank will enlist the help of other investment banks to sell the securities, forming a underwriting syndicate. The investment bank, which could be multiple firms that the company selected, is called the originating house (aka syndicate manager, managing underwriter), which selects the members of the syndicate and determines how many shares each will get, and manages the overall process. The underwriting manager determines, along with the issuer, the offering price and the time of the offering, and controls all advertising for the new issue. The managing underwriter not only handles the federal registration, and responds to any deficiency letters from the SEC, but, since state security laws (aka Blue Sky laws) require that the new issue must be registered in each state in which it is offered, the manager also ensures that the security has been Blue Skyed.
The members sign an Agreement Among Underwriters (AAU), which stipulates, among other things, the management fee, and that they will represent the issuer. Also, the percentage of each underwriter's allotment of the new issue is stipulated. There may be an overallotment provision (aka green shoe, because this provision was 1st used in an underwriting for the Green Shoe Company) that will allow the underwriters to get more shares at the original price if the issue turns out to be oversubscribed.
Each member of the syndicate must also sign an Underwriting Agreement (UA) which stipulates the relationship of the syndicate members and the issuer, including their rights, obligations, terms, and conditions, and that the issuer is required to sell and the syndicate members are required to purchase a specified number of shares. This agreement is signed when the registration of the new securities becomes effective.
There are 2 types of obligations concerning the purchase of the new issue by the syndicate members. The most common type—the divided account, or Western account—requires that the syndicate member sells its allotted shares of the new issue, but it is not obligated to sell the unsold shares of other members. The undivided account (aka Eastern account) requires that each underwriting member to buy not only his own allotted shares, but also the same percentage of unsold shares of other members as the member's allotment percentage.
Example — Western and Eastern Accounts:
5 members of the syndicate are each allotted 20% of a new issue of $100,000,000 of securities. All but $5,000,000 has been sold. If the members are bound by an Eastern account, then each member will be required to buy 20%, or $1,000,000, of the unsold shares. If, however, they agreed to a Western account, then no member has to buy the unsold shares of any other member.
In addition, each member of the syndicate, including the originating investment bank may have selling groups (also called selling syndicate), consisting of other investment bankers, dealers, and brokers, that may also sell to investors. Members of the selling group, which can number in the hundreds for some issues, sign a Dealer Agreement (aka Selling Agreement) that stipulates the terms of the relationship, including the commission (also called selling concession), the date of termination—typically 30 days—and whether the selling groups have to buy unsold shares.
The main advantage of syndication is that it reduces risk by sharing it among the syndicate members, and each syndicate member and their selling groups have their own customers to whom they can sell the new issues, so it reduces the amount that any one brokerage would have to sell, making it more likely all of the new issue would be sold.
A typical compensation arrangement for a syndicate is the originating house gets a small percentage of the underwriting spread of the entire issue; the other members of the syndicate get a percentage of all issues sold by them or their selling groups; and the selling groups get a percentage of what they sell. Below is a typical compensation schedule for a new security priced at $20 per share:
| Sample Distribution of Investment Banking Fees | ||
|---|---|---|
| Public Offering Price | $20.00 | per share |
| Manager's Fee | $.25 | The underwriting manager receives this for all share's sold. |
| Underwriter's Allowance | $1.75 | The syndicate member receives this for every share that it sells. |
| Selling Concession | $1.00 | What the selling group earns per share. |
| Reallowance | $.50 | Per share for a broker or dealer who is not part of the syndicate or any selling group. |
| Amount Received by Issuer | $18.00 | per share |
Note that the underwriting manager as well as other members of the syndicate can also sell directly to investors, and if they do, they get the percentage that would otherwise go to compensate everyone below them. So if the underwriting manager sold directly to their institutional investors, for instance, then the manager would get the full $2 of the underwriting spread. If a member of the syndicate sells to their own customers, they would get $1.75 of the spread, because $.25 of that spread still goes to the underwriting manager, but they would also get $.75 of any shares sold by their selling groups.
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