Definition
Best Effort Arrangement: In the context of investment banking, a “Best Effort Arrangement” is a contractual agreement wherein investment bankers (underwriters) agree to use their best efforts to sell a new issue of securities to the public. Unlike a firm commitment underwriting where underwriters buy the entire issue outright and assume the risk of selling it, in a best effort arrangement, the underwriters do not purchase the securities upfront. They act as agents with an option to buy and a license to sell the securities.
Examples
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Initial Public Offering (IPO): A company going public for the first time might use a best effort arrangement to reduce the risk involved. The investment bankers will try their best to sell as many shares as possible, but the unsold shares will not be their responsibility.
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Small or Speculative Companies: Companies that are relatively unknown or have a speculative nature might engage in best effort arrangements since the demand for their shares can be uncertain.
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Private Placements: In some cases, private placements where securities are sold to a limited number of investors could use a best effort basis to gauge market interest and limit risk exposure.
Frequently Asked Questions (FAQs)
What is the main difference between a Best Effort Arrangement and Firm Commitment?
A best effort arrangement does not guarantee the sale of the entire issue; investment bankers only agree to make their best effort to sell the securities. In contrast, a firm commitment involves the underwriters purchasing the entire issue outright and reselling it to the public.
Why might a company choose a Best Effort Arrangement?
Companies may choose a best effort arrangement to minimize risk and costs associated with an underwritten public offering. This method is particularly useful for companies whose securities are less attractive to underwriters due to high perceived risk or lower market demand.
How do investment bankers get compensated in a Best Effort Arrangement?
Investment bankers typically receive a fee based on the number and amount of securities sold. This fee is usually a percentage of the total sales proceeds.
Are Best Effort Arrangements suitable for all companies?
Best effort arrangements are generally suitable for smaller or riskier companies with uncertain market demand for their securities. Larger, established companies usually prefer firm commitment underwritings for the certainty and financial backing it provides.
Is there a minimum number of securities that must be sold in a Best Effort Arrangement?
Generally, there is no minimum; however, the offering might specify conditions or thresholds that need to be met for the deal to be viable.
- Underwriting: The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (equity or debt).
- Firm Commitment: An underwriting arrangement where investment bankers purchase the entire issue of securities from the issuer and then resell them to the public.
- Syndicate: A group of investment banks that come together to share the risk and help distribute a new securities issue.
- Initial Public Offering (IPO): The first time that the stock of a private company is offered to the public.
Online References
Suggested Books for Further Studies
- Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions by Joshua Rosenbaum and Joshua Pearl
- Common Stocks and Uncommon Profits and Other Writings by Philip A. Fisher
- Security Analysis by Benjamin Graham and David L. Dodd
Fundamentals of Best Effort Arrangement: Investment Banking Basics Quiz
### What is a key characteristic of a Best Effort Arrangement?
- [ ] The investment bankers purchase all the securities outright.
- [ ] The investment bank guarantees the sale of all securities.
- [x] The investment bankers strive to sell as many securities as they can without buying them upfront.
- [ ] The issuing company does not pay any fees to the investment bank.
> **Explanation:** In a best effort arrangement, investment bankers do not purchase the securities outright but instead use their best efforts to sell the securities to the public.
### Why might a company opt for a Best Effort Arrangement?
- [x] To reduce the risk and costs associated with underwriting.
- [ ] To ensure that all securities are sold at a higher price.
- [ ] To guarantee full subscription of their issue.
- [ ] To limit the number of securities being offered.
> **Explanation:** Companies may choose a best effort arrangement to minimize underwriting risk and costs, especially if the demand for their securities is uncertain.
### Who bears the risk in a Best Effort Arrangement?
- [ ] The investment bank
- [ ] The investors
- [x] The issuing company
- [ ] Both the investment bank and the investors
> **Explanation:** In a best effort arrangement, the issuing company bears the risk as the investment bankers are not obliged to buy any unsold securities.
### How do investment bankers get paid in a Best Effort Arrangement?
- [x] They receive a fee based on the successful sale of the securities.
- [ ] They get a fixed upfront fee regardless of sales.
- [ ] They are compensated based on the volume of the issue, not sales.
- [ ] They do not get paid until the entire issue is sold out.
> **Explanation:** Investment bankers are typically compensated with a fee that is a percentage of the securities they successfully sell.
### What type of companies most often use Best Effort Arrangements?
- [ ] Large established companies
- [ ] Banks and financial institutions
- [x] Smaller or speculative companies
- [ ] Government entities
> **Explanation:** Smaller or speculative companies, where the market demand is uncertain, often use best effort arrangements.
### Which term is NOT related to Best Effort Arrangements?
- [ ] Underwriting
- [ ] Initial Public Offering (IPO)
- [ ] Syndicate
- [x] Dividend Reinvestment Plan (DRIP)
> **Explanation:** Dividend Reinvestment Plan (DRIP) is not related to best effort arrangements but is a method by which investors reinvest their cash dividends into additional shares.
### What is the principal role of an investment banker in a Best Effort Arrangement?
- [ ] To provide a loan for the issuing company.
- [ ] To manage the firm’s daily operations.
- [x] To use their best efforts to sell the securities to the public.
- [ ] To develop a marketing strategy for the company.
> **Explanation:** The primary role is to use their best efforts to sell the securities on behalf of the issuing company.
### Which market players form a syndicate?
- [ ] Independent investors
- [x] A group of investment banks
- [ ] Government agencies
- [ ] Corporate Boards
> **Explanation:** A syndicate is formed by a group of investment banks coming together to share the underwriting risk and assist in distributing a new securities issue.
### How does Firm Commitment differ from Best Effort Arrangement?
- [ ] It does not involve any investment bankers.
- [ ] It eliminates the need for issuing companies to sell securities.
- [ ] It is used only by government entities.
- [x] The investment bankers buy the entire issue outright in a Firm Commitment.
> **Explanation:** In a firm commitment, the investment bankers buy the entire issue outright and resell it to the public, unlike in best effort arrangements.
### In which scenario would best effort underwriting NOT be ideal?
- [ ] Launching a tech startup's IPO.
- [ ] Raising capital for a speculative venture.
- [x] Offering shares for a well-established, high-demand public company.
- [ ] Private placements of securities.
> **Explanation:** Well-established companies with high-demand securities typically prefer firm commitments to ensure full sale and financial backing.
Thank you for exploring our article on Best Effort Arrangements and testing your understanding through our quiz! Continue to expand your investment banking knowledge with consistent learning and practice!
