A bought deal is a type of underwriting arrangement where an investment bank or underwriter purchases the entire issuance of shares from a company before the Initial Public Offering (IPO). This ensures that the company will receive a specific amount of capital, as the underwriter agrees to buy all the shares at a predetermined price, thereby assuming the risk of reselling those shares to the public.
Bought Deal
A bought deal is an underwriting arrangement in which an investment bank (underwriter) commits to purchasing an entire issuance of shares from a company before its Initial Public Offering (IPO). This agreement guarantees the company a specific amount of capital, as the underwriter assumes the responsibility of selling the shares to investors at a later stage. Bought deals offer rapid and assured funding, making them attractive for companies seeking quick access to capital. However, they come with unique trade-offs, particularly in pricing and investor engagement.
Key Features of a Bought Deal
Commitment
In a bought deal, the underwriter’s commitment is central. The underwriter agrees to purchase all the shares from the company at an agreed-upon price. This price is generally based on current market conditions, the company’s financial health, and the broader economic environment. Unlike a “best efforts” arrangement, where the underwriter only attempts to sell the shares, a bought deal guarantees that the issuer will receive a specific amount of capital. This provides companies with predictable funding but transfers risk to the underwriter.
Risk Transfer
A defining feature of a bought deal is the transfer of sales risk. Once the underwriter purchases the shares, the risk of selling them to the public lies with them. If market conditions change unfavorably, or if there is less investor interest than expected, the underwriter bears any potential financial loss. This risk-transfer component incentivizes underwriters to choose bought deals in conditions where they anticipate high demand.
Speed and Certainty
Bought deals can be executed faster than traditional book-building methods. This efficiency arises because the process involves direct negotiation between the issuer and the underwriter, without the need to gauge broader investor sentiment first. For companies that require immediate capital, the speed of bought deals can be highly advantageous. Furthermore, this approach provides certainty, allowing companies to confidently plan their strategic investments, acquisitions, or operational expansion.
Process of a Bought Deal
- Negotiation and Agreement
The bought deal process begins with the issuer and underwriter negotiating terms, including the price per share and the total number of shares to be issued. Both parties evaluate factors such as market trends, company valuation, and the economic environment. Once agreed, the terms are formalized in a contract, guaranteeing the issuer the agreed-upon funds. - Underwriter Purchases Shares
After finalizing the terms, the underwriter buys all the shares from the issuer at the predetermined price. This immediate transaction provides the issuer with rapid access to capital, a vital feature for companies needing funds quickly for strategic purposes. - Resale to Investors
The underwriter then resells the shares to investors, either through a public offering or private placements. Their objective is to sell at a price higher than the purchase price to generate a profit. This step often involves strategic planning to identify suitable investors, such as institutional investors, who might find the offer appealing. - Marketing and Distribution
The success of a bought deal often depends on effective marketing and distribution. Underwriters utilize their reputation and network to build interest and demand for the shares. This may involve roadshows, where company executives present growth plans and performance metrics to potential investors. The underwriter’s reputation plays a crucial role here, as strong credibility and a well-connected network help ensure effective distribution.
Advantages of Bought Deals
Certainty for Issuers
The primary advantage of a bought deal is the certainty it provides. Issuers are guaranteed to raise the capital they need, which reduces the uncertainty associated with other underwriting methods. This is particularly valuable for companies needing immediate funds for pressing strategic investments, acquisitions, or operational expansions. In volatile markets, this certainty can be essential for financial stability and business continuity.
Speed
The speed of the bought deal process allows companies to access funds quickly, which can be crucial for seizing market opportunities or addressing urgent financial needs. This fast-tracked method bypasses the prolonged book-building process, making it ideal for companies aiming to capitalize on time-sensitive opportunities.
Market Conditions
Bought deals are particularly advantageous in strong market conditions. When demand for shares is high, underwriters can secure profits by reselling shares at a higher price. Favorable conditions make it more likely for underwriters to take on bought deals, as they can leverage investor interest to maximize returns.
Disadvantages of Bought Deals
Potentially Lower Price for Issuers
Issuers may receive a lower price per share compared to traditional book-building methods. The underwriter factors in their own risk, which might result in a more conservative price. For issuers, this could mean raising slightly less capital than might be possible with a pricing approach driven by investor demand.
Risk for Underwriters
Underwriters face substantial risk in bought deals, as they are responsible for reselling the shares at a profit. If market conditions deteriorate after the purchase or investor demand weakens, they risk financial loss. This risk is one reason underwriters may be selective when entering bought deals, generally favoring companies with a positive market outlook.
Limited Investor Engagement
Bought deals allow for less time to generate investor interest and engagement than traditional methods. The shorter marketing timeframe may impact investor familiarity and excitement about the shares, potentially affecting their post-IPO performance. In cases where the shares lack demand, this can hinder initial trading performance.
Example: Shopify’s 2020 Bought Deal
In 2020, Shopify Inc., a leading e-commerce platform, executed a bought deal to quickly raise capital for growth initiatives. Shopify reached an agreement with several investment banks to sell shares worth approximately $1.5 billion. This deal allowed Shopify to secure funds rapidly, benefiting from underwriter confidence in the tech market’s strength. The swift access to capital enabled Shopify to invest in new technologies, expand its market presence, and accelerate its growth trajectory. This example underscores how bought deals can fuel rapid growth in high-potential industries.
When to Consider a Bought Deal
For companies considering a bought deal, the following factors may indicate suitability:
- Immediate Capital Needs: Bought deals are optimal for companies requiring fast capital access.
- Market Demand Confidence: Companies in high-demand industries, such as tech or biotech, often attract underwriters willing to assume risk.
- Risk Tolerance for Pricing: Companies that prioritize certainty over potentially higher capital might find bought deals advantageous.
Comparison to Other Underwriting Arrangements
Bought Deal vs. Traditional Book-Building
- Bought Deal: Offers speed and certainty but may result in a lower price per share due to the underwriter’s risk assumption.
- Traditional Book-Building: Involves gauging investor interest, potentially achieving higher prices but at the cost of a longer process.
Bought Deal vs. Shelf Offerings
- Shelf Offerings: Allow companies to gradually issue shares over time, often used by companies looking to optimize timing and demand.
- Bought Deals: Provide immediate capital, making them better suited for urgent needs.
Conclusion
A bought deal is a strategic financing option that provides companies with rapid and guaranteed capital. Its appeal lies in speed and assurance, as issuers can rely on secure funding to pursue immediate objectives. However, the trade-off includes potentially lower pricing and greater risk for underwriters, who may face challenges reselling the shares. For companies willing to accept this balance, a bought deal presents a compelling path to secure funds and execute strategic growth initiatives.
Key takeaways
- Guaranteed Capital: In a bought deal, the underwriter buys all shares from the company, ensuring guaranteed capital, unlike “best efforts” deals.
- Risk Transfer: The underwriter assumes the risk of reselling the shares to the public, bearing financial responsibility if shares do not sell as anticipated.
- Speed and Access to Capital: Bought deals are executed quickly, enabling companies to act on strategic opportunities without delay.
- Trade-offs: This method offers certainty and speed but may yield a lower price per share for the issuer, as underwriters account for the associated risk.
- Market Impact: The limited marketing period may impact initial post-IPO performance if investor engagement is low.
Further Reading:
IPO (Initial Public Offering)
Raising Capital Through New Share Issues