How Underwriting Works: IPOs, Follow-Ons and Bond Deals

Underwriting is the process by which an investment bank helps an issuer sell new securities to investors, and in most deals takes on some or all of the risk that the securities will not sell. How underwriting works is easiest to follow in sequence: the issuer picks banks, the banks and lawyers prepare disclosure, the securities are marketed and priced, the banks allocate them to investors, and the syndicate supports trading for a short period afterward. The same basic pattern applies to initial public offerings, follow-on stock sales and bond issues, with differences in documents and timing. Readers of investment bank news will see these steps described in the shorthand of “bookrunners,” “pricing” and “greenshoes.”

In brief

• Federal securities law defines an “underwriter” broadly, to include anyone who buys from an issuer for distribution or helps sell for it.
• In a firm commitment deal, the underwriters buy the securities and resell them; in a best efforts deal, they only try to sell.
• Underwriters are paid through a discount, often called the gross spread, and FINRA reviews whether total compensation is fair and reasonable.
• Rules cover disclosure, trading around the offering, and compensation.

What the law says an underwriter is

The Securities Act of 1933 defines “underwriter” as any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or in the direct or indirect underwriting of it. The definition excludes a person whose interest is limited to a commission from an underwriter or dealer that does not exceed the usual and customary distributors’ or sellers’ commission.

The breadth of that definition matters. Participants in a distribution can face liability for misstatements in the offering documents, and the law gives underwriters a defense if they conduct reasonable investigation, often called due diligence. This is why banks insist on legal opinions, auditor comfort letters and detailed management questions before a deal launches.

The parties

• The issuer: the company or government selling securities. Its management, board, auditors and lawyers prepare the documents.
• Lead or bookrunning managers: the banks that run the process, build the order book and price the deal. One bank often takes “left” position and leads on logistics.
• Co-managers and syndicate members: additional banks that add distribution reach or relationships.
• Underwriters’ counsel and issuer’s counsel: law firms that draft documents and give legal opinions.
• Auditors: they deliver comfort letters on the financial information.
• Regulators: the SEC reviews registration statements; FINRA reviews underwriting terms and arrangements for many public offerings.
• Investors: mostly institutions in a typical offering, plus retail through brokers in some.

Regulation S-K Item 508 requires a registration statement to name the principal underwriters, state the amounts underwritten, identify any underwriter with a material relationship with the registrant and describe the nature of the underwriters’ obligation to take the securities.

Firm commitment, best efforts and other structures

Firm commitment. The underwriters agree to purchase the entire issue from the issuer at a set price, and then resell. If investors do not buy, the underwriters bear the loss. Most large public offerings use this structure, which is why banks size deals carefully and test demand before they sign the underwriting agreement.

Best efforts. The underwriter acts as agent and tries to sell as much as it can without committing to buy it. It may include conditions such as a minimum amount that must be sold, or the deal is cancelled. This structure appears more often in smaller or riskier offerings.

Standby and rights offerings. In a rights offering, existing shareholders get the first chance to buy; a standby underwriter agrees to take whatever is unsold.

Bought deals and overnight deals. A bank buys a block from the issuer or a holder at a negotiated price and resells it quickly. These are common for follow-on sales by listed companies and shareholders because they compress the marketing period.

Shelf takedowns. An issuer may register securities in advance for a delayed or continuous offering. SEC Rule 415 sets conditions for registering securities to be offered on a continuous or delayed basis. After the shelf is effective, an issuer can come to market quickly, which is why established issuers often sell bonds on short notice after an earnings release.

The timeline of an IPO

An initial public offering has a longer path than a repeat deal. A typical sequence:

1. Selection and preparation. The issuer chooses bookrunners, often after a competitive pitch process, and begins due diligence, audited financials and corporate housekeeping.
2. Registration statement. The company files a registration statement with the SEC. It contains a prospectus describing the business, risks, financials, use of proceeds and the plan of distribution. The SEC staff reviews it and comments, and the company amends it in response.
3. Marketing. After the prospectus carries a price range, management and the banks hold meetings with investors, often called a roadshow, and the banks gather indications of interest.
4. Bookbuilding. The bookrunners record investor orders at various prices to see how demand is distributed. The quality of demand matters as well as the quantity: long-term investors are generally preferred to short-term traders.
5. Pricing. After the registration statement is declared effective, the issuer and the banks agree on a final price, and the underwriting agreement is signed, usually the evening before trading begins.
6. Allocation. The banks decide which investors receive shares and in what amounts.
7. Closing. A few days after pricing, the securities are delivered and the issuer receives the net proceeds.
8. Aftermarket support. For a limited time, the syndicate manages trading in the new shares, subject to anti-manipulation rules.

How bookbuilding works in numbers

Suppose a hypothetical company offers 10 million shares in a range of 18 to 20 dollars. Orders arrive for 40 million shares at the top of the range. The book is four times covered. The company and the lead banks may raise the price, increase the number of shares, or both, and then allocate. Allocation is a judgment: banks weigh the investor’s size, investment horizon and relationship with the firm. The deal’s success is judged both by the price achieved and by how the shares trade in the first days.

The greenshoe and stabilization

Many equity offerings include an over-allotment option, known as a greenshoe, which lets the underwriters sell more shares than the base deal and then buy them from the issuer if demand holds. The underwriters sell, for example, 15 percent more shares than the base amount in the initial allocation, a short position that they can cover by exercising the option if the stock trades up, or by buying shares in the market if it trades down. Buying in the market supports the price. The percentage here is an example, not a rule for every deal.

This kind of support is regulated. Regulation M, Rule 101, makes it unlawful in connection with a distribution of securities for a distribution participant or an affiliated purchaser to bid for, purchase or attempt to induce others to bid for or purchase a covered security during the applicable restricted period, with defined exceptions. Rule 104 of Regulation M separately addresses stabilizing, syndicate covering transactions and penalty bids, and makes it unlawful to carry them out except as the rule allows. Stabilization is meant to prevent or slow a price decline during the distribution, not to push the price up.

Lock-ups

Underwriting agreements often include lock-up agreements in which insiders and pre-IPO holders agree not to sell for a set period after the offering. They prevent a flood of insider sales while the shares are finding a market. The length and exceptions are negotiated and disclosed in the prospectus.

How underwriters are paid

The usual compensation is the underwriting discount, also called the gross spread: the difference between the price the public pays and the price the issuer receives. It is typically split into three components, a management fee for the lead banks, an underwriting fee for the risk, and a selling concession for the firms that place the securities. Spreads differ by deal type, size and market. Bond spreads are generally smaller as a percentage than equity spreads, and large offerings often pay lower percentages than small ones. Exact figures appear in the prospectus.

FINRA Rule 5110 applies to many public offerings. It states that no member may participate in a public offering where the terms and conditions, including the aggregate amount of underwriting compensation, are unfair or unreasonable. Underwriting compensation can include items beyond the discount, such as expense reimbursements, warrants or other securities received, and the rule governs how those are treated. The prospectus must disclose the compensation arrangements.

Debt underwriting

For corporate bonds, the process shares the same architecture but differs in details.

• Documents. Investment-grade issuers often use shelf registration, so a short pricing supplement is enough to launch. Others sell under exemptions, such as offerings to qualified institutional buyers.
• Pricing. Bonds are priced as a spread over a benchmark government yield. The banks build a book, release “price thoughts,” and tighten the spread as orders arrive.
• Ratings. Credit ratings shape investor demand and pricing.
• Speed. A frequent issuer can price a bond within hours.

Municipal and government debt follows its own regimes, with different disclosure rules and market practice.

What can go wrong

• Market moves. If conditions deteriorate between launch and pricing, the offering can be priced lower, shrunk or postponed.
• Disclosure problems. Material misstatements create liability for issuers and, subject to defenses, underwriters.
• Weak demand after pricing. In a firm commitment deal, the banks hold the unsold securities and the loss.
• Conflicts. Banks may lend to or advise the issuer as well as underwrite; compensation and relationships must be disclosed.

Common misconceptions

“The underwriter picks the price alone.” The price is negotiated between the issuer and the bookrunners, informed by investor demand. The issuer’s board approves it.

“Underwriters always take the risk.” Only in a firm commitment. In best efforts deals the issuer bears the risk of an incomplete sale.

“A deal that rises on its first day was a success for everyone.” A big first-day gain can mean the issuer left money on the table by pricing low.

“Bank approval means the SEC approved the offering.” The SEC does not approve or endorse securities. Its review concerns disclosure.

FAQ

What is the difference between an underwriter and a broker?

A broker executes orders for customers. An underwriter helps an issuer sell new securities and often buys them first. The same firm often does both, in different parts of the business.

How long does an IPO take from start to finish?

It varies widely. Preparation and SEC review can take months, and the marketing and pricing phase is usually measured in days to a couple of weeks. Market conditions can pause the process.

What is a bookrunner?

A bank that manages the order book and the allocation of securities. Deals often have several, and the order of names on the cover page shows the roles.

What is the greenshoe for?

It gives underwriters flexibility to meet extra demand and to support the price in the aftermarket without taking unlimited risk.

Where can I see who underwrote a deal and how they were paid?

In the prospectus, which names the principal underwriters and describes the plan of distribution and compensation, and in filings on the SEC’s EDGAR database. League tables compiled by data providers summarize the same information, as discussed in our guide to deal rankings.