This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
The advantages of this arrangement to a corporation are well worth a considerable sum of money. In the first place, an issue once underwritten is an assured success. The corporation may at once proceed with whatever projects the fresh capital is designed to finance. There is no tedious and costly period of waiting during which the securities are in process of being sold. Many new enterprises are of such a nature that time is an important element in making them successful. If, for example, a new plant is being built in order to handle certain contracts, or if an effort is being made to forestall competition, it might be fatal to the project if its inception were delayed until after all the stock or bonds have been sold.
A second highly important advantage is that underwriting assures success in raising the entire sum called for. Frequently any amount less than the entire sum would be a burden rather than a source of strength to the corporation. For example, a company operating department stores intends to establish a new store on a large scale in another city. The stores previously owned are developed as far as can profitably be done. To establish the proposed new store with insufficient capital would be merely to make it second-rate and to invite quick failure.
Let us suppose that the company, which needs $1,000,000 for the new store, authorizes an issue of additional stock for that amount, and sells only one-half the stock, thus raising $500,000. It is then in a position where it can go neither forward nor backward. It cannot very well return the money which has been raised, nor can it proceed with the upbuilding of the new store. It is possible, in a case of this kind, to take subscriptions to the new issue, the subscription agreement providing that it shall not be binding unless the complete issue is subscribed for within a given period. However, this introduces an element of uncertainty that interferes with effecting the sale of the security issue. Underwriting protects the corporation against all risk and difficulty of this nature. It can be certain of receiving the amount of capital that is agreed upon within a definite period.
Incidentally, the underwriting agreement carries with it the advantages that go with all other arrangements whereby a banking house agrees to market the securities of a corporation. The corporation gets the benefit of the specialized experience and judgment of the bankers, and thus the risk of making a serious error in the form or in the price of the new security is reduced to a minimum.
Not only is the underwriting agreement advantageous to the corporation, but also to the purchasers of the security issue. In the first place, the fact that an underwriting syndicate has been formed - provided it is made up of first-class houses -is in the nature of a guarantee that the security is sound. A still greater advantage is the insurance of the purchaser of the security against the same contingencies which would be harmful to the corporation; for it must be borne in mind that the moment the purchaser becomes a stockholder or a bondholder in the corporation, he begins to share in its good or evil fortunes. If the corporation, therefore, is injured by dragging out the sale of a new security issue over a long period, or by bringing out a security issue which finally is not entirely disposed of, the purchaser of the securities is one of the sufferers. It is, therefore, to his advantage that the issue should be underwritten and its success thereby assured.