A Reexamination of the Costs of Firm Commitment and Best Efforts IPOs

Lena Chua

The Financial Review, 1995, vol. 30, issue 2, 337-65

Abstract: Ritter documents that best efforts IPOs are, on average, more costly to issue than firm commitment IPOs. This paper explains the phenomenon. Two component costs of going public are analyzed: underpricing and underwriter compensation. The model, based on a disagreement about firm value between underwriters and issuers, shows that underpricing is higher for firms using best efforts contracts as these firms, on average, are more speculative. Underwriter compensation is hypothesized to be higher for firms using best efforts contracts because of the high costs of market making for these firms in the after market and the high distribution costs associated with the high risk of a failed offer. Empirical tests strongly support the propositions. Copyright 1995 by MIT Press.

Date: 1995
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