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Perceptions on the Role of Underwriting Fees in Accessing Public Markets

There is a continuing debate about contributing factors to a declining IPO market with some pointing to the high level of IPO costs, particularly underwriting fees. Narrative disclosure of these costs may serve to make issuers more aware of those costs (as compared to those of alternative capital formation strategies) and may lead to calibrating those levels more closely in relation to the costs of taking a company public.

Prof. John C. Coffee, Jr.’s recent blog post, “The Irrepressible Myth That SEC Overregulation Has Chilled IPOs” (May 29, 2018), appearing in The CLS Blue Sky Blog, cites a study on the most significant costs of an IPO and suggests that those costs will not likely be reduced by deregulation alone. According to the study, underwriting discounts account for between 71% and 79% of the total average costs of an IPO.

Prof. Coffee does not suggest the SEC, FINRA or any other federal or state agency attempt to reduce underwriting discounts; rather, he asserts the “real” costs slowing the IPO on-ramp are diverted executive time, multinational roadshow expenses and potential litigation costs.

Despite Prof. Coffee’s contention, it is not entirely clear that underwriting costs do not contribute to IPO shyness. We frequently hear a common refrain from executives of public companies and potential IPO issuers that an IPO is “expensive money.” Whether they are referring to the direct IPO costs alone or together with the resulting regulatory and compliance costs thereafter, that is the perception of many chief executive officers.

SEC Commissioner Robert J. Jackson Jr. addressed underwriting fees in his CLS Blue Sky blog post, “The Middle-Market IPO Tax” (April 26, 2018). Commissioner Jackson observed that the standard underwriting fee for a middle-market IPO has been static at 7% of the offering size since his early days as an investment banker, even though with technology and competition there should now be “better pricing on IPOs.” Accordingly, Commissioner Jackson labels the 7% discount an “IPO tax” “standing between entrepreneurs and our public markets.” He cites Jay Ritter’s seminal 2000 study on the costs of midsized IPOs, which concluded that the 7% figure seemed to be unrelated to the costs of taking a company public and even “investment bankers readily concede that [IPO costs] are high.”

To reduce the 7% middle-market IPO tax, Commissioner Jackson wrote:

I urge my colleagues on the Commission to consider more robust disclosure rules regarding both the direct and indirect costs of an IPO. In particular, underwriters should disclose and highlight for entrepreneurs and investors the total costs of taking the company public …. Bankers should also be required to explain why these costs are justified ….

Regulation S-K Item 508 - Plan of Distribution requires an issuer “to provide a table that sets out the nature of the compensation and the amount of discounts and commissions to be paid to the underwriter.” Since the “nature of the compensation” must be stated in a table, the disclosure requirement is presumably meant to be streamlined and, as compared with the itemized disclosure called for by Regulation S-K Item 511 - Other Expenses of Issuance and Distribution, short of meaningful information for issuers and investors. There does not appear to be any further instruction that requires an issuer (or underwriter) to shed light on how the total underwriting discounts and commissions are allocated within the underwriter’s organization or for which services they are meant to compensate.

It may be that disclosure relating to the components of underwriting discounts and commissions are so oblique that few company board members and CEOs understand the underlying services they are paying for with the underwriting discount.

In Ken Langone’s excellent book, I Love Capitalism!, he recounts his urging of shared commissions for his brokerage firm’s industry research coverage. He writes:

“Mr. Brown,” I said, “I want to do something, and I’d like you to agree to it. I want to allocate a certain percentage of those commissions to the research department for the analysts who helped bring in this business. Mr. Brown, these guys downstairs are great; I don’t think you understand the quality of talent you’ve got down there.”

Similarly, in public subscription rights offerings, a dealer-manager often re-allows a percentage (sometimes in an amount of up to one-half) of the total commissions to other registered broker-dealers (especially online brokers) whose brokerage clients purchase shares in the offering pursuant to the exercise of their subscription rights, in order to incentivize the brokers to make their clients aware of the offering.

In the IPO market, transactions frequently require at least six months of intense work for the sole book-running manager. The manager may take 60% of the underwriting commissions, sharing the balance with co-managers. For smaller offerings, this amount may not ultimately prove economical to the investment bank considering the work load and the risk of not getting paid unless the offering takes place. This is especially the case compared to registered secondary offerings where there is an already established trading market, less of a vetting and due diligence process, and a streamlined timeframe. Small-cap IPO companies often have no or limited strategic or venture capital prior investment, require aftermarket support and stabilization activities, and are more vulnerable to adverse changes in market and industry conditions.

More transparent narrative disclosure of the components of underwriting discounts and commissions, by far the largest contributor to IPO costs, may dispel the perception that IPO underwriting fees are too expensive. This disclosure may even lead to leveling the playing field with intermediary fees charged in alternative capital formation transactions and result in more companies accessing public markets for their funding.