Standby Underwriting

Standby underwriting is a type of agreement to sell shares in an initial public offering (IPO) in which the underwriting investment bank agrees to purchase whatever shares remain after it has sold all of the shares it can to the public. In an underwriting standby (standby) agreement, the underwriter agrees to purchase any remaining shares at the subscription price, which is lower than the stock's market price. This underwriting method guarantees the issuing company that its IPO will raise a certain amount of money.

Although the ability to buy shares below the market price may appear to be an advantage of standby underwriting, the fact that there are shares left over for the underwriter to purchase indicates a lack of demand. Standby underwriting thus transfers risk from the company that is going public (the issuer) to the investment bank (the underwriter). Because of this additional risk, the underwriter's fee may be higher. Other options for underwriting an IPO include a firm commitment and a best efforts agreement.

In a firm commitment underwriting agreement, the underwriting investment bank provides a guarantee to purchase all securities being offered to the market by the issuer, regardless of whether it can sell then to investors. Issuing companies prefer firm commitment underwriting agreements over standby underwriting agreements – and all others – because it guarantees all the money right away. Typically, an underwriter will agree to this type of arrangement only if the IPO is in high demand because it shoulders the risk alone and requires the underwriter to put its own money at risk. If it can't sell securities to an investor, it will have to figure out what to do with the remaining shares – hold them and hope for increased demand or possibly try to unload them at a discount. Typically, the underwriter will insist on a "market out clause" that would free them from the commitment to purchase all the securities in case of an event that degrades the quality of the securities. However, poor market conditions are typically not among the acceptable reasons to invoke a market out clause.

In a best efforts underwriting, the underwriters will do their best to sell all the securities being offered, but the underwriter is not obligated to purchase all the securities under any circumstances. This type of underwriting agreement will typically come into play if demand for an offering is lower. Under this type of agreement, any unsold securities will be returned to the issuer.