Underwriting of Shares in Modern Financial Markets
When a company plans to raise capital by issuing new shares, it faces the risk that investors might not buy all of them. To prevent this, companies often use underwriting of shares, a financial guarantee that ensures all shares are sold, even if the public does not purchase them. This process gives stability and confidence to the entire share issue. Just like the redemption of preference shares, underwriting of shares plays a vital role in corporate finance and investment markets.
What Is Underwriting of Shares?
Underwriting of shares means a financial agreement between a company and an underwriter (usually a financial institution or broker). The underwriter agrees to buy all or part of the shares that remain unsold after the public offering. In simple words, the underwriter promises that the company will receive its intended funds, no matter how many shares the public subscribes to.
Underwriting acts as a safety net for companies planning to go public. It ensures that the company can raise enough money to fund its operations, expansion, or new projects. Without underwriting, many firms might struggle to attract investor confidence during an initial public offering (IPO).
Why Underwriting of Shares Is Important
The underwriting of shares plays an important role in both financial stability and investor trust. It guarantees that the company will get its required capital and also boosts the credibility of the share issue. Investors are more willing to buy shares when they see a well-known financial institution backing the issue.
Companies benefit because underwriting helps them transfer the risk of unsold shares to professional underwriters. It also helps maintain good market reputation and makes future fundraising easier.
Types of Underwriting of Shares
Different types of underwriting agreements exist, and each type defines how much risk the underwriter assumes. Here’s a simple table that shows the main types and their key details:
| Type of Underwriting | Meaning | Underwriter’s Risk Level |
|---|---|---|
| Firm Commitment | The underwriter buys the entire issue and sells it to the public. | High |
| Best Efforts | The underwriter sells as many shares as possible but doesn’t guarantee full sale. | Moderate |
| All or None | If all shares are not sold, the issue is canceled. | Medium |
| Standby Underwriting | Used during rights issues; underwriter buys shares not subscribed by existing shareholders. | Low |
Each type of underwriting of shares offers a different level of safety for both the company and the underwriter. In a firm commitment, the risk is highest, but the company gets full assurance. In a best-effort agreement, the company may still face a shortfall if demand is low.
The Process of Underwriting of Shares
The process of underwriting of shares follows a structured path. First, the company approaches financial institutions or brokers who specialize in underwriting. The underwriter evaluates the company’s financials, reputation, and the potential of its public issue.
After negotiations, an underwriting agreement is signed. This agreement includes the number of shares, issue price, commission rate, and the nature of underwriting (firm, best-efforts, etc.). Once the issue is open to the public, the underwriter markets and sells the shares. If the public doesn’t buy all of them, the underwriter purchases the remaining ones.
This process ensures financial protection for the company while also helping underwriters earn commissions or spreads for taking the risk.
Underwriting Commission and Liability
Underwriters receive a commission for their services, usually a percentage of the total issue amount. This commission compensates them for the risk of unsold shares. The company pays the commission after the share issue is complete, whether or not all shares are sold to the public.
Underwriters also carry a liability for the shares they agree to underwrite. If the public subscribes to fewer shares than expected, the underwriter must buy the unsold portion. This liability ensures that the company’s capital-raising target is fully met.
Here’s a short table summarizing these concepts:
| Term | Description |
|---|---|
| Underwriting Commission | Payment to underwriters for taking the risk and helping sell shares. |
| Underwriting Liability | The number of shares the underwriter must buy if the issue is undersubscribed. |
The Role of Underwriters in the Market
Underwriters do more than just guarantee share sales. They also analyze the company, set the issue price, and create investor interest. By evaluating the company’s financial performance and potential, underwriters help determine a fair price that attracts investors while ensuring good returns for the issuer.
They also conduct roadshows and investor meetings to promote the share issue. Their reputation often adds credibility, influencing investors to trust the offering. In global markets, investment banks like Goldman Sachs, Morgan Stanley, or ICICI Securities are well-known underwriters.
This is especially crucial in countries like India, which has a dynamic financial market and shares international borders with multiple nations. For instance, India shares border with how many countries is a common question reflecting its global connections — similarly, its financial ties span multiple economies through stock exchanges and underwriting institutions.
Advantages of Underwriting of Shares
The underwriting of shares offers several benefits to both companies and investors. For companies, it ensures assured capital, helping them plan confidently for expansion or debt repayment. It also transfers the risk of market failure to professionals who specialize in managing it.
For investors, underwriting signals that a reliable financial institution has examined the company’s background and approved the issue. This builds trust and stability in the stock market.
Another major advantage is that underwriters help stabilize share prices after listing. By using strategies like over-allotment or “greenshoe options,” they prevent extreme price fluctuations in the early trading days.
Devolvement and Oversubscription in Underwriting
When the share issue is not fully subscribed, the devolvement clause comes into play. It means the underwriter must purchase the unsold shares according to the agreement. This ensures the company still receives the full capital amount.
However, if the issue is oversubscribed — meaning investors apply for more shares than offered — the underwriter’s job becomes easier. In this case, the underwriter doesn’t need to buy any shares but still earns their commission.
This balance of risk and reward makes underwriting one of the most critical elements of financial markets.
Example of Underwriting of Shares
Suppose XYZ Ltd. wants to raise $10 million by issuing one million shares at $10 each. The company signs a firm commitment underwriting agreement with ABC Finance. If the public subscribes to only 700,000 shares, ABC Finance must purchase the remaining 300,000 shares. The company thus receives its full $10 million.
The underwriter might sell the remaining shares later when market conditions improve, aiming for profit. In return, ABC Finance earns a commission, say 2% of the total issue amount, for providing this financial assurance.
Comparison Between Underwriting and Other Financial Methods
| Basis | Underwriting of Shares | Direct Public Issue |
|---|---|---|
| Risk | Shared or transferred to underwriter | Entirely on company |
| Assurance | Full capital guaranteed | No capital guarantee |
| Investor Confidence | Higher due to underwriter’s credibility | Depends on market trust |
| Marketing | Underwriter helps in promotion | Company promotes itself |
This comparison shows that underwriting provides a safer and more structured approach to raising funds compared to a direct public issue.
Modern Practices and Regulations
Modern-day underwriting of shares is regulated by bodies like SEBI in India and the SEC in the United States. These regulators ensure that the process is transparent, fair, and protects investor interests. Companies must disclose underwriting details in their prospectus, including the names of underwriters, their commitments, and commissions.
Technology has also changed the landscape. With online trading and global investors, underwriting now includes digital marketing, analytics, and online subscriptions. This modernization makes the entire process faster and more efficient.
Conclusion
The underwriting of shares remains a cornerstone of the capital market system. It ensures financial stability for companies, confidence for investors, and liquidity for the economy. By taking on risk and providing expertise, underwriters act as bridges between companies seeking capital and investors seeking opportunities.
In simple terms, underwriting transforms uncertainty into assurance. Whether it’s a small business going public or a multinational launching an IPO, underwriting guarantees that the show goes on — even if the crowd is smaller than expected.