Underwriter Compensation Structure: Can It Really Bond Underwriters?

Published date01 February 2014
Date01 February 2014
AuthorJacqueline L. Garner,Beverly B. Marshall
The Financial Review 49 (2014) 21–48
Underwriter Compensation Structure: Can
It Really Bond Underwriters?
Jacqueline L. Garner
Mississippi State University
Beverly B. Marshall
Auburn University
Underwriter compensation can be structured as all cash or a combination of cash and
warrants. Using a sample of small initial public offerings (IPOs), we find that underwriter
compensation contracts that include warrants in exchange for cash can serve as certification
for IPO firms by substituting for reputation capital. When underwriters accept warrants when
they could have received more cash compensation, the IPOs avoidthe well documented long-
run underperformance. However, when underwriters receive warrants after maximizing cash
compensation, the IPO experiences higher underpricing and poorer long-run performance.
The findings are consistent with a motivation by the underwriters to circumvent regulatory
Keywords: initial public offerings, underwriting compensation, underpricing, regulatory
JEL Classifications: G18, G24
Corresponding author: Department of Finance and Economics, Mississippi State University, 312
McCool Hall, Mississippi State, MS 39762; Phone: (662) 325 6716; Fax: (662) 325-1977; E-mail:
Wethank the editors (Robert and Bonnie VanNess) and two anonymous referees for their helpful comments
and suggestions. We also thank participants at the 2010 Financial Management Association meeting.
C2014 The Eastern Finance Association 21
22 J. L. Garner and B. B. Marshall/The Financial Review 49 (2014) 21–48
1. Introduction
Underwriter compensation in initial public offerings (IPOs) is regulated by
Financial Industry Regulatory Authority (FINRA) Rule 5110, which imposes limits
on both the types and the amount of compensation. In general, cash compensation is
limited to 13%, composed of a 10% limit on the spread and a 3% limit on the expense
allowance. Noncash compensation, including warrants, is also subject to regulations,
which include policies on the lock-up period, warrant term, quantity of warrants
issued, and the warrant valuation method. Further, FINRA Notice to Members 92–53
provides guidelines on total compensation, which vary with the size of the offering
and are suggested to represent “the maximum amount of compensation ‘underwriters
and related persons’ may receive in a public offering” (NASD Manual and Notice to
Members, www.nasd.com).
For larger offerings, Chen and Ritter (2000) show that total compensation al-
lowed by the regulations is approximately 7% and results in the clustering of spreads
for offers over $20 million.1However, for offers below $20 million, the regulatory
guidelines cap total compensation at levels between 7.52% and 15.80% of proceeds
resulting in significant variation in the actual level and types of compensation for
small offerings. For example, for offerings below$12 million, the guidelines suggest
total compensation at levels over 13% of offer proceeds, which exceeds the limit
on cash compensation. Therefore, it is not surprising that warrants are accepted as
compensation among small offerings where the dollars generated as a percentage of
the offer size could be insufficient to cover expenses and the risk of underwriting the
offering. For these underwriters, once cash compensation is maximized, warrants are
simply included by default.
However, warrantsare not always included in compensation by default. Among
our sample of underwriters receiving warrant compensation, cash compensation is
not at the maximum allowable level about 40% of the time. This suggests that the un-
derwriters either trade off cash compensation for warrant compensation or are forced
by the issuing firm to take contingent compensation. The presence of significant
regulations on compensation implies that less reputable underwriters would extract
excessive compensation in their absence. This suggests that significant monopsony
power over the issuing firm could be present despite what appears to be a relatively
crowded market of underwriters. Lesser knownunderwriters could signal their quality
to investors in the compensation contract by setting a low levelof cash compensation
and accepting contingent compensation in the form of warrants as conjectured by
Bae and Jo (2007). On the other hand, the issuing firm could force less proven un-
derwriters to take contingent compensation as a bonding mechanism, in an effort to
encourage effective performance of responsibilities surrounding the offering. Either
1The compensation guidelines for offers of $50 million or more is 6.89%, whereas the compensation
guideline for offers of $20 million is 7.52%.

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