What is Best Efforts?
How Does Best Efforts Work?
A best efforts agreement does not guarantee that all of the securities in the issue must be sold. An issuer and underwriter agree upon a minimum level of sales and once the minimum has been reached, the underwriter is not responsible for any unsold securities.
Let’s assume Company XYZ plans to go public and it hires an investment bank to become their underwriter and arrange the offering. The investment bank’s job as the underwriter is to get the best price it can for the issued shares, and sell as many as possible.
Underwriters determine the best price and size in an offering by pitching their clients’ offering to institutional investors -- these are called road shows. The underwriter then considers these expressions of interest when advising the issuer on an appropriate offering size and price.
In a best efforts agreement, the underwriter also handles the actual sale of the securities. Sometimes the underwriter forms a syndicate and enlists the help of other banks to help sell the issue -- increasing the sales effort behind the issue and reducing the pressure on each bank to sell to its client base.
SEC Rule 10b-9 and Regulation S-K require underwriters to disclose a best efforts agreement in the issuer’s prospectus, and how long the offering is open. If the underwriters have committed to sell a minimum number of securities, this too must be disclosed in the prospectus. Additionally, Rule 15c2-4 requires underwriters to deposit the proceeds from a best-efforts offering into an escrow account or special bank account until the issuer and the underwriter determine that all the underwriter’s requirements are satisfied.
Why Does Best Efforts Matter?
In a best efforts agreement, not only does the issuer not know the exact amount of capital raised until the offering is closed, the issuer bears the risk of not selling enough securities to raise the desired capital. This not only wastes money on underwriting and filing fees, it leaves the issuer with the same need for cash that prompted the sale of the securities in the first place.
Best efforts offerings are commonly open longer than firm-commitment offerings -- allowing more time for potential negative news or events to occur that would make the offering seem overpriced -- exacerbates these risks.
Best efforts offerings are considered riskier than firm-commitment offerings by most analysts and investors -- at times too risky.