A company first informs the underwriter how much capital it wants to raise through IPO. Then the merchant bank analyzes the market conditions and the goodwill the company has in the market and lets the firm know if they can raise that much amount. Once the capital to be raised is frozen fee structure to be paid to the investment bank (merchant bank) is finalized.
There are two types of structures as far as the underwriting is concerned.
Firm Commitment basis
Best efforts basis
Firm Commitment basis: In this type of agreement the investment bank agrees to underwrite the issue i.e. it buys the shares from the firm and sells them in IPO. If some part of the issue is not subscribed then it will have to take the responsibility and hold the shares. However it can sell them off in secondary market in favorable conditions, if they want. In this process, the merchant banker acts as a dealer and the spread (difference between the price it offers to public and the price at which it buys from the firm) is the profit.
Best efforts basis: In this type of agreement the investment bank gives its best efforts to get the issue subscribed fully at a pre-determined price. But it doesn’t have any responsibility to assume the unsubscribed portion of the issue, if any.
Sathish Emmadi
Sathish Emmadi is a co-founder & editor at Lastbull.com. He is presently working in IT for one of the world’s top mutual fund companies. Handled multiple projects in BFSI (Banking,Financial Services and Insurance) domain. An Engineering Graduate from NITW.
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