Underwriting A Stock

What is underwriting? Well, when a corporation decides that it is time to go public, issuing stock to investors, it must hire an investment banking firm to help sell the corporation's stock.

Basically, what is happening is the investment banker is acting as the middle-man between the public and the corporation. Now in most cases, the underwriter will buy the stock from the corporation and sell it at a higher price to the public (this is how investment bankers make their money off underwriting). The difference between the price that the underwriter pays for the stock and the price the public pays for the stock is known as the underwriting spread. Also, because most corporations are selling millions of shares at the IPO (initial public offering) they will form an underwriting syndicate, which is other investment bankers who co-purchase the stock in a set of allotments. This reduces some of the risk that the investment banker takes from buying all of the shares.

The underwriting process is really complicated because of all the rules and regulations imposed by the SEC (Security and Exchange Commission). Another thing that syndicates can do is bid on the stock price during the offering in order to "stabilize" the stock price. Basically, the stabilizing process is to secure the syndicates purchase and to allow the price of the stock to rise due to demand. When the syndicate bids on the stock price it must be less then or equal to the offering price, this regulates the syndicate from making the price too high and then selling it off quickly. The syndicate must also notify the public that it is bidding on the stock, that way the public is aware the syndicate is trying to stabilize the stock. Moreover, the SEC also requires that the underwriter investigate that company who is going public. This protects the public from buying shares of a company that has no intention of making money, but that just wants to profit on the offering of its stock price. The process of investigating the company going public is referred to as due diligence.

There are many types of underwriting arrangements in which a stock can be done. One is where the underwriter acts as an agent and tries to sell as much of the stock it can at the current market price. This is known as the best effort arrangement. There are also many other types of arrangements when issuing stock. The main thing to know is that the terms in which stocks are issued are usually a contract between the company going public and the investment banker/syndicate who is bringing the stock to the market. The most important thing to know about the underwriting process is that it is highly regulated by the SEC and that it can be an opportune time to for young investors to research good companies and make long-term investments.