Question

In this firm commitment offering who bears the financial risk? Who would bear the risk in a best efforts offering?

Answer 1

An investment banker agrees to underwrite an issue of 10 million shares of stock for TWResearch, Inc. on a firm commitment basis. The investment banker pays $10.50 per share to TWResearch, Inc. for the 10 million shares of stock. It then sells those shares to the public for $11.20 per share.

Answer:

In a firm commitment offering, the investment banker bears the financial risk and buys the securities from TWResearch to sell to the public at its own terms.

In a best efforts offering, TWResearch, Inc. bears the financial risk and only makes its best efforts to sell the securities without buying them from TWResearch.

Explanation:

With a firm commitment offering, the investment banker enters into an agreement to purchase all the securities from TWResearch at an agreed price, and then, commits itself to selling the securities to the public at its own chosen price.  As it pockets the ensuing gain or loss, the investment banker bears all the financial risk.  With a best efforts offering, the investment banker does not assume inventory risk, but makes its best efforts in selling the securities. TWResearch bears the residual financial risk since the underwriter forwards to TWResearch all  the proceeds from the issue, after deducting its commission.