What is Underwriting of Shares?

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Grade Level:

Class 12

AI/ML, Physics, Biotechnology, FinTech, EVs, Space Technology, Climate Science, Blockchain, Medicine, Engineering, Law, Economics

Definition

What is it?

Underwriting of shares is an agreement where a financial institution (called an underwriter) guarantees to buy any shares of a company that are not bought by the public during a new share issue. It acts like an insurance policy for the company issuing shares, ensuring all shares are sold.

Simple Example

Quick Example

Imagine your school is selling tickets for its annual day play. If the school asks a big local shop to promise to buy any unsold tickets, that shop is 'underwriting' the tickets. Even if students don't buy all tickets, the school is sure to get money because the shop will buy the rest.

Worked Example

Step-by-Step

A company, 'TechWiz Ltd.', wants to issue 10,000 shares at Rs. 100 each. They enter into an underwriting agreement with 'FinServe Bank' for 90% of the issue.

Step 1: Calculate the total shares underwritten. 90% of 10,000 shares = 9,000 shares.
---Step 2: The public applies for 8,500 shares.
---Step 3: Calculate the shares FinServe Bank needs to buy (underwriting obligation). Total shares issued - shares bought by public = 10,000 - 8,500 = 1,500 shares.
---Step 4: Check if the obligation is within the underwritten amount. 1,500 shares is less than 9,000 shares.
---Answer: FinServe Bank will have to buy 1,500 shares at Rs. 100 each, paying Rs. 1,50,000 to TechWiz Ltd.

Why It Matters

Underwriting is crucial for companies in FinTech, EV manufacturing, or even space tech, as it helps them raise large amounts of money confidently. This ensures their projects, from new apps to rocket launches, get funded. Understanding this can open doors to careers in investment banking, financial analysis, or even starting your own venture.

Common Mistakes

MISTAKE: Thinking underwriting means the underwriter always buys all the shares. | CORRECTION: The underwriter only buys the shares that the public doesn't subscribe to, up to their agreed-upon guarantee.

MISTAKE: Confusing underwriting with simply advising a company on a share issue. | CORRECTION: Underwriting involves a financial guarantee to purchase unsold shares, which is much more than just advising.

MISTAKE: Believing underwriting is free for the company. | CORRECTION: Companies pay a fee, called underwriting commission, to the underwriter for taking on the risk of buying unsold shares.

Practice Questions

Try It Yourself

QUESTION: A company issues 5,000 shares. An underwriter guarantees 100% of the issue. If the public subscribes to 4,800 shares, how many shares will the underwriter buy? | ANSWER: 200 shares

QUESTION: 'GreenEnergy Ltd.' wants to raise capital by issuing 20,000 shares at Rs. 50 each. 'MegaFinance' agrees to underwrite 80% of the issue. If the public applies for 18,000 shares, what is MegaFinance's obligation? | ANSWER: 0 shares (because 18,000 shares subscribed by public is more than 80% of 20,000 shares, which is 16,000 shares. The underwriter only steps in if public subscription is less than the underwritten amount.)

QUESTION: 'DigitalDreams Corp.' issues 1 lakh shares at Rs. 20 each. They have two underwriters: 'Alpha Bank' for 60% and 'Beta Investments' for 40%. The public subscribes to 75,000 shares. How many shares will each underwriter buy? | ANSWER: Alpha Bank: 0 shares, Beta Investments: 0 shares (Total public subscription of 75,000 shares is more than the total underwritten shares of 1 lakh, so neither underwriter has an obligation. If the question implies a firm underwriting where they buy a certain amount regardless, the context would specify. Based on standard understanding, they only buy unsold shares.)

MCQ

Quick Quiz

What is the primary purpose of underwriting shares for a company?

To get free financial advice

To guarantee that all shares issued will be sold

To reduce the price of shares

To increase public awareness about the company

The Correct Answer Is:

The core function of underwriting is to assure the issuing company that its share issue will be fully subscribed, thereby guaranteeing the sale of all shares, even if the public doesn't buy them all.

Real World Connection

In the Real World

When a big Indian company like Reliance Jio or Zomato decides to go public (called an IPO - Initial Public Offering) and list its shares on the stock exchange, they often use underwriting services. Large banks like ICICI Bank or SBI Capital Markets act as underwriters, ensuring that the company successfully raises the funds needed for its expansion plans, like building new data centers or launching new services.

Key Vocabulary

Key Terms

UNDERWRITER: The financial institution that guarantees to buy unsold shares | INITIAL PUBLIC OFFERING (IPO): The first time a company sells its shares to the public | COMMISSION: The fee paid to the underwriter for their service | PUBLIC SUBSCRIPTION: The number of shares bought by the general public

What's Next

What to Learn Next

Now that you understand underwriting, you should explore 'Initial Public Offering (IPO)'. Underwriting is a crucial part of an IPO, and learning about IPOs will show you the bigger picture of how companies raise money from the public.