In a securities offering, “best efforts” refers to a contractual term in which the underwriter promises to do the best it can to sell as much of a securities offering as possible.
Understanding “Best Efforts”
In a best efforts offering, not all securities are required to be sold. Generally, the underwriter (the investment bank or syndicate) and the issuer (the company) will agree on a minimum amount of sales that must be attained. Once that threshold is met, the underwriter is not liable for any unsold securities.
Underwriters will generally go on roadshows to pitch the issuer’s company and to determine the size and price of the offering. It is important to note that as opposed to an underwritten offering, where the underwriter purchases the entire issue and sells to the public, the investment bank is given the option to purchase the shares and act as brokers.
Therefore, the underwriter faces significantly less risk in a best efforts offering as they would not face the risk of not being able to sell the entire issue. As a result, underwriters in a best efforts offering are usually paid a flat fee with no commission. If the underwriter is unable to meet the sales quota, the underwriter generally foregoes the fee paid by the issuer.
Best Efforts Offering vs. Underwritten Offering
Consider an example where the issue is $5 million.
In a best efforts offering, the underwriter is given the option to purchase the entire issue of $5 million. If there is investor demand for only $3 million of the issue, the underwriter could purchase $3 million of the issue to sell to investors. Assuming that the amount meets the sales threshold, the underwriter could leave the remaining $2 million issue unsold.
In an underwritten offering, the underwriter would need to purchase the entire issue of $5 million. In such a scenario, the underwriter would face the risk of not being able to sell the entire $5 million issue and lose money.
It is important to note that there is an option to purchase the issue in a best efforts offering while there is a requirement to purchase the issue in an underwritten offering. The diagram below illustrates the fact:
Reasons for a Best Efforts Offering
A best efforts offering is commonly utilized during poor market conditions or for securities that carry more risk. In such scenarios, the demand for securities is generally lower, and it would be risky for the underwriter to offer an underwritten offering.
For example, if the underwriter knows that an issue would generate low demand, there would be no reason for the underwriter to offer an underwritten offering to purchase the entire issue and risk being not able to sell the issue to investors. The underwriter might choose instead to offer a best efforts offering and attempt to sell enough shares to meet the sales threshold needed to attain the fixed fee.
ABC Investment Bank is an underwriter for XYZ Company. The company is looking to raise $500 million in an initial public offering by selling 500 million shares. Due to volatile market conditions, ABC Investment Bank noted that the demand for securities was likely to be low. As such, XYZ Company requested a best efforts offering for a fixed fee of $20 million.
In a roadshow, it was determined that there was demand for 150 million shares of the company. If the sales threshold is $200 million, should ABC Investment Bank conduct a best efforts offering for XYZ Company?
Since there is only demand for 150 million shares, the sales generated would only be $150 million. As such, ABC Investment Bank would not be able to meet the sales threshold. The bank should not conduct a best efforts offering for ABC Company as they would not be able to meet the sales threshold to receive their fixed fee.
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