Standby Underwriting: What it is, How it Works

What Is 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 a standby agreement, the underwriter agrees to purchase any remaining shares at the subscription price, which is generally lower than the stock's market price.

This underwriting method guarantees the issuing company that the IPO will raise a certain amount of money.

Understanding Standby Underwriting

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 for the offering. 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.

Standby vs. Firm Commitment Underwriting 

In a firm commitment, 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 the shares 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 a firm commitment underwriting only if the IPO is in high demand because it shoulders the risk alone; it requires the underwriter to put its own money at risk. If it cannot sell securities to investors, 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, booking a loss on the shares.

The underwriter in a firm commitment underwriting will often 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. Poor market conditions are typically not among the acceptable reasons, but material changes in the company's business, if the market hits a soft patch, or weak performance of other IPOs are sometimes reasons underwriters invoke the market out clause.

Standby vs. Best Efforts Underwriting

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 the demand for an offering is expected to be lackluster. Under this type of agreement, any unsold securities will be returned to the issuer.

As the name suggests, the underwriter simply promises to make their best effort to sell shares. The arrangement reduces the risk to the underwriter because they are not responsible for any unsold shares. The underwriter can also cancel the issue altogether. The underwriter receives a flat fee for its services, which it will forfeit if it opts to cancel the issue.