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| Firm Commitment |
The underwriter agrees to purchase the entire securities issue from the issuer. He/ she will then resell them to institutional and individual investors. Hence, the underwriter will assume the market risk associated with the purchase of the entire issue.
Any unsold securities will be held by the underwriter. This agreement is different from the best efforts deals, where the underwriter does not buy any of the IPO issue and does not guarantee that all the new securities will be sold.
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Welch notes, “In best-efforts offerings, minimum sales constraints permit issuers to precommit to withdraw the offering if a fixed minimum number of shares is not sold. In firm-commitment offerings, the over allotment option allows the underwriter to increase sales when demand is strong.”
Bower (1989) shows that the choice between firm commitment and best efforts affects both a firm’s cost of obtaining capital and investors’ perceptions about firm value.
