Ipo - Best Efforts and Firm Committment

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IPO refers to a situation when a company issues common stock or shares to the public for the first time. The process generally involves one or a syndicate of investment banks. The sale of shares in an IPO may take several forms. In a firm commitment agreement, the bank acts as an underwriter by purchasing the securities from the issuer at a mutually agreed price with a view of reselling them to the public at a margin. For the issuer, it is the safest but the most expensive type of agreement. It is the safest because the underwriter takes the risk of sale. It is expensive because the risk is reflected in the potentially lower sale price, since the underwriter seeks to make around 7% profit from the spread between the purchase and resale price. A related disadvantage of ‘firm commitment’ is underpricing, which results in "money left on the table" - lost capital that could have been raised for the company had the stock been offered at a higher price. For instance, in 1998, the shares of theglobe.com underwritten by Bear Stearns were priced at $9 per share. At the opening of trading, they rocketed around 1000% to $97 per share. It is estimated that around $200 million was left on the table as a result: see further Ibbotson, Sindelar and Ritter (1994). In the best efforts contract the bank simply agrees to sell as many securities as possible but does not buy them outright and does not guarantee a sale price. Instead, securities are marketed at the price set by the customer and the bank operates on a commission basis. Best efforts offerings are mainly used for securities with higher risk, such as unseasoned offerings. The upside for the customer is the potential of selling above the expected price range, as was the case with Tesla (automobile manufacturer) IPO in June 2010, which opened at $17 per share, above the $14-$16 expected range, reaching $23.89 per share by the time the market closed (a considerable 40.5% increase); and General Motors IPO in November 2010,...
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