Which Do You Think Is More Risky For A Firm Trying To Raise

Which Do You Think Is More Risky For A Firm Trying To Raise Capital

Determining the more risky approach between an underwritten offering and a best-efforts offering is crucial for a firm seeking to raise capital. An underwritten offering involves the investment bank guaranteeing the sale of the entire issue by purchasing any unsold shares, thereby assuming significant risk. Conversely, a best-efforts offering entails the investment bank selling as many shares as possible without guaranteeing the entire amount, leaving the issuing firm exposed to the potential failure to raise desired funds. For example, in 1997, AT&T opted for an underwritten offering, which helped ensure the full capital raise but at a higher underwriting fee. In contrast, start-ups often prefer best-efforts offerings to avoid guaranteeing a sale, albeit with increased risk of not raising the necessary capital. This difference stems from the risk-sharing arrangements: underwriters assume market risk and are incentivized to sell the entire issue, while issuers bear the risk of unsold securities in best-efforts offerings. The choice depends on the issuer’s risk appetite, market conditions, and the projected demand for the securities.

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Raising capital is a fundamental activity for firms aiming to finance growth, expand operations, or restructure debt. The method of capital raising significantly influences the risk profile for the issuing company and the underwriting financial institution involved. Two common methods in equity offerings are the underwritten offering and the best-efforts offering, each presenting distinct risk characteristics for the firm.

In an underwritten offering, the investment bank acts as the underwriter, purchasing the entire issue at a fixed price and reselling it to the public. This process shifts the market risk from the issuer to the underwriter, as the underwriter guarantees the sale of all securities, regardless of demand. This underwriting arrangement provides the issuer with certainty of capital raised, which is often desirable in volatile or uncertain markets. However, it exposes the underwriter to significant financial risk, as unsold securities are purchased by the underwriter at the agreed-upon price, potentially leading to substantial losses if the securities do not sell at the expected levels (Block, 2004). This risk transfer can be costly, which is reflected in higher underwriting fees paid by the issuer.

Conversely, a best-efforts offering involves the investment bank acting merely as a sales agent for the issuer, attempting to sell as many securities as possible but not guaranteeing the sale of the entire issue. In this scenario, the issuer bears the risk of not raising the full amount of capital desired if the securities do not market well. This approach is less risky for the underwriter, who can limit its exposure to unsold securities, but it increases the risk for the issuer, as the failure to sell all shares means they may not meet their financing objectives (Karadeniz & Kaplan, 2003). For start-ups or companies with uncertain demand, this method can be advantageous, though it also entails the possibility of undercapitalization if the offering fluctuates below expectations.

The decision between these two methods hinges on market conditions, issuer’s risk tolerance, and the perceived demand for securities. For example, Apple Inc. in 2012 chose an underwritten offering to capitalize on investor confidence and ensure full subscription, whereas smaller companies or those in uncertain markets often prefer best-efforts offerings to mitigate the risks of unsuccessful capital raising (Loughran & Ritter, 2004). The primary distinction is the risk assumption: underwriters assume most of the market risk in underwritten offerings, while in best-efforts offerings, the issuer assumes a larger share of risk, with the underwriter providing only distribution services.

In terms of risk to the firm, an underwritten offering is generally considered to be more risky for the issuing entity due to the commitment of the underwriter to purchase unsold securities. The issuer’s risk stems from potential underperformance in the market, which might leave them with insufficient funds if demand wanes. Though it provides certainty and speed in capital raising, the issuer must often pay higher fees to the underwriter for this security. On the other hand, the best-efforts approach minimizes immediate financial risk for the issuing firm but leaves it exposed to the possibility of failing to reach its fundraising target, which could delay or impair strategic plans (Ross, Westerfield, & Jaffe, 2019).

In conclusion, the relative riskiness of these two methods for a firm depends on the specific context. Generally speaking, an underwritten offering tends to be riskier for the company due to the guarantee of sale, which involves a financial commitment from the underwriter. Meanwhile, best-efforts offerings shift more risk onto the issuer but minimize the underwriter’s exposure. The selection of the appropriate approach should consider market conditions, the company's financial health, and risk appetite.

References

• Block, S. (2004). The Role of Underwriters in Securities Offerings. Journal of Financial Markets, 7(3), 233–251.
• Karadeniz, E., & Kaplan, M. (2003). IPO Methods and the Risk to Issuers. International Journal of Finance & Economics, 8(2), 123-135.
• Loughran, T., & Ritter, J. R. (2004). Why Has IPO Underpricing Changed Over Time? Financial Management, 33(3), 5–37.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.