Financing Sources - What exacting is underwriting and how does it work?

Underwriting refers to a financial institution’s support for the sale or issuance of stock.

There are four main types of underwriting:

• Firm commitment. An arrangement in which an underwriter assumes all the risks of bringing new securities issues to market by buying the issue from the issuer and guaranteeing the sale of a certain minimum number of shares to investors.
   
• Dutch auction. Offers come in and determine highest beginning price. The bank buys a set amount for a specific value. Clearing price is determined by investor demand, as revealed through the bidding process, rather than set in advance as in the firm commitment.
   
• Best efforts. An underwriting in which an investment bank, acting as an agent for an issuer, agrees to do its best to sell an offering to the public, but does not buy the securities outright or guarantee a particular financial result from the issuance.
   
• Bought deal. One investment bank buys the entire offering and resells it.

Sometimes bankers keep their initial purchase conservative and add an overallotment provision in the underwriting agreement of an IPO. The provision allows the underwriting syndicate to buy up to an additional 15 percent of the shares at the offering price if public demand for the shares exceeds expectations and the stock trades above its offering price.

This provision, nicknamed “green shoe” after the first company to use it (The Green Shoe Company), can be used in both IPOs and private offerings.