A “firm commitment” is a term often used in finance and investing. It refers to an underwriter’s agreement to assume all inventory risk and purchase all securities directly from the issuer for sale to the public in the context of an initial public offering (IPO) or a secondary offering.
In other words, in a firm commitment agreement, the underwriter (typically an investment bank) agrees to buy the entire issue of securities (like stocks or bonds) from the issuer and then sell these securities to the public. If the underwriter cannot sell all of the securities to the public, it must hold onto the securities itself. Essentially, the underwriter is “guaranteeing” that the issuing company will raise a certain amount of capital from the offering.
A firm commitment underwriting agreement is in contrast to a best-efforts underwriting agreement, in which the underwriter agrees to sell as many securities as possible but doesn’t guarantee the sale of the entire issue.
For example, if Company A wants to go public and raise capital, it might enter a firm commitment agreement with an investment bank. The investment bank agrees to buy all of Company A’s shares at a predetermined price and then sell those shares to the public. The investment bank assumes the risk of not being able to sell all the shares to the public.
Firm commitment agreements are common in large public offerings where the issuer wants to ensure it raises a certain amount of capital, and the underwriter is confident it can sell the entire issue to the public.
Example of a Firm Commitment
Let’s consider a fictional company, “TechStart,” which has decided to go public through an initial public offering (IPO).
TechStart engages an investment bank, let’s call it “WallStreet Bank,” to underwrite the IPO. They agree on a “firm commitment” underwriting arrangement.
In this agreement, WallStreet Bank commits to buy all 10 million shares of TechStart’s IPO at $20 per share. This means WallStreet Bank will pay TechStart $200 million (10 million shares x $20) for the shares, which WallStreet Bank will then sell to the public.
Under the firm commitment agreement, WallStreet Bank is obligated to buy all the shares, even if they can’t sell them all to the public. So if WallStreet Bank can only sell 8 million shares to the public and is left with 2 million unsold, they still need to pay TechStart the full $200 million. The risk here for WallStreet Bank is that they can’t sell all the shares and end up holding some themselves.
On the other hand, TechStart gets the advantage of certainty. They know they will receive $200 million from the IPO, regardless of how many shares WallStreet Bank can sell.
This is an example of a firm commitment in the context of an IPO. It illustrates how this arrangement can provide certainty for the issuer while placing the risk of unsold shares on the underwriter.