Underwriters are financial professionals that take on someone else’s risk in exchange for a fee. They evaluate risk and then determine a price for financial transactions such as purchasing an insurance policy or taking out a mortgage.
In the world of equities, underwriters work with private companies to value their operations, connect with potential investors, and issue stock on a public exchange for the first time.
What Is an IPO Underwriter?
An initial public offering (IPO) underwriter is a financial specialist who works closely with a company to issue stock on the public markets. They are almost always IPO specialists who work for an investment bank.
Stock underwriters guide the company that’s issuing stock through the IPO process, making sure they satisfy all of the regulatory requirements imposed by the Securities and Exchange Commission (SEC), as well as the rules imposed by the exchange, such as the Nasdaq or the New York stock Exchange (NYSE).
An IPO’s underwriter creates the market for the stock by contacting a wide range of institutional investors, including mutual funds, insurance companies, pension funds and more. They first reach out to this network of investors to gauge their interest in the company’s stock, and to see what those investors might be willing to pay. The underwriter uses those conversations to set the price of the IPO.
From there, the underwriter of an IPO works with the company issuing the stock through the many steps that lead up to its IPO. On the day of the IPO, the underwriter is responsible for purchasing any unsold shares at the price it set for the IPO.
The way that IPO underwriters get paid depends on the structure of the deal. Typically, IPO underwriters buy the entire IPO issue and then resell the stocks, keeping any profits, though in some cases they receive a flat fee for their services.
What Is IPO Underwriting?
An IPO is the process through which a company has its shares sold to regular investors on a public market. The company issuing stock works with the IPO underwriters throughout the process to determine how to price their stock and gin up interest among potential investors.
Most companies find their way to the investing public through a group of underwriters who agree to purchase the shares, and then sell them to investors. But only a few broker-dealers belong to this “underwriting syndicate,” and some of them sell exclusively to institutional investors.
What Does an IPO Underwriter Do?
In essence, an underwriter in an IPO is the intermediary between a company’s executives and owners, such as venture capitalists, seeking to issue shares of stock and public-market investors.
When a company seeks funding from the capital markets, it must make dozens of decisions. How much money does the company want to raise? How much ownership will it cede to shareholders? What type of securities should it issue? Those are just a few, including what kind of relationship the company wants to have with its underwriter.
Underwriting agreements take different forms, but in the most common agreement, the underwriter agrees to purchase all the stock issued in the IPO, and sell those shares to the public at the price that the company and the underwriter mutually agree to. In this agreement, the underwriter assumes the risk that people won’t buy the company’s stock.
Sometimes a company works with a group of underwriters, who assume the risk, and help the company work through the many steps toward an IPO. This involves issuing an S-1 statement. This is the registration form that any company needs to file with the SEC to issue new securities. The statement is how companies introduce themselves to the investing public. S-1 requires companies to lay out plans for the money they hope to raise. The IPO underwriter also creates a draft prospectus for would-be investors.
The IPO Underwriting Process
Underwriting an IPO can take as little as six months from start to finish, though it often takes more than a year. While every IPO is unique, there are generally five steps that are common to every IPO underwriting process
Step 1. Selecting a Bank
The issuing company selects an underwriter, usually an investment bank. It may also select a group or syndicate of underwriters. In that case, one bank is selected as the lead, or book-running, underwriter.
One kind of agreement between the issuing company and the underwriter is called a “firm commitment,” which guarantees that the IPO will raise a certain sum of money. Or they may sign a “best efforts agreement,” in which the underwriter does not guarantee the amount of money they will raise. They may also sign in “all or none agreement.” In this agreement, the underwriter will sell all of the shares in the IPO, or call off the IPO altogether.
There is also an engagement letter, which often includes a reimbursement clause that requires the issuing company to cover all the underwriter’s out-of-the-pocket expenses if the IPO is withdrawn at any stage.
Step 2. Conduct Due Diligence and Start on Regulatory Filings
The underwriter and the issuing company then create an S-1 registration statement. The SEC then does its own due diligence on the required details in that document. While the SEC is reviewing it, the underwriter and the company will issue a draft prospectus that includes more details about the issuing company. They use this document to pitch the company’s shares to investors. These roadshows usually last for three to four weeks, and are essential to gauging the demand for the shares.
Step 3. Pricing the IPO
Once the SEC approves the IPO, the underwriter decides the effective date of the shares. The day before that effective date, the issuing company and the underwriter meet to set the price of the shares. Underwriters often underprice IPOs to ensure that they sell all of their shares, even though that means less money for the issuing company.
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Step 4. Aftermarket Stabilization
The underwriter’s work continues after the IPO. They will provide analyst recommendations, and create a secondary market for the stock. The underwriter’s stabilization responsibilities only last for a short period of time.
Step 5. Transition to Market Competition
This final stage of the process begins 25 days after the IPO date, which is the end of the “quiet period,” required by the SEC. During this period, company executives can not share any new information about the company, and investors go from trading based on the company’s regulatory disclosures to using market forces to make their decisions. After the quiet period ends, underwriters can give estimates of the earnings and stock price of the company.
Some companies also have a lock up period before and after they go public, in which early employees and investors are not allowed to sell or trade their shares.
The Takeaway
The IPO underwriter plays an important role in the process of taking a company public. IPOs are an important part of the stock market, and they present an opportunity for investors to get in on a company that may be entering a growth phase by allowing them to buy IPO stocks.
If you’re interested in investing in IPOs, one way to get started is by opening an account with the SoFi Invest® brokerage platform.The platform has an IPO investing feature that allows members to access IPO shares before they’re listed on public exchanges.
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SoFi Invest®
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Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.
New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.
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