Used in the context of an initial public stock offering, or IPO, the gross spread ratio refers to the underwriters' cut of the money raised in the offering. Investors may not realize that when a company "goes public" at, say, $40 a share, the company usually doesn't get $40 for every share sold. A significant slice goes to middlemen involved in the sale.
In most cases, when a company goes public, it doesn't actually sell that stock to the public. It instead sells stock to one or more investment banks, and the bankers sell it to buyers they've lined up. Having investment banks buy the shares -- known as underwriting the offering -- guarantees to the company that it will raise money from the IPO regardless of the actual demand in the market. But this guarantee comes at a cost. The price the banks pay the company for the shares is lower than what they resell them for. The difference in price is the gross spread.
Figuring the Ratio
Say a company is going public at $40 a share. That's the price that investors will initially have to pay to get stock. They'll pay that amount to an investment bank. The investment bank, however, bought the shares directly from the company for $37 apiece. The gross spread on this IPO, then, is $3. Expressed as a ratio, the gross spread is 7.5 percent -- that is, the $3 spread is 7.5 percent of $40. If the underwriters had bought shares for $36, the spread would be $4, and the ratio would be 10 percent.
The higher the gross spread ratio, the greater the proportion of the IPO proceeds that are going to the investment banks rather than the company the IPO is supposed to fund. An exhaustive study of gross spreads by researchers at Oxford University found that in the U.S. IPO market, where major investment banking is concentrated among a handful of firms, underwriters almost always charge a gross spread ratio in the neighborhood of 7 percent. In Europe, on the other hand, where more investment banks in multiple countries are competing for IPO business, ratios tend to be lower and distributed over a wider range.
Factors in the Spread
The gross spread is intended to compensate the investment banks for both their work and their risk. The banks do most of the legwork involved with an IPO, researching the market to set the price, handling regulatory matters and lining up buyers. Underwriters also shoulder the risk of the IPO. If the investing public doesn't want stock at the IPO price, the underwriters will be stuck with their shares and may have to sell them at a loss. On the other hand, if it's an IPO with high demand, the underwriters aren't taking on much risk at all -- but thanks to the spread, they'll still be compensated as if they are.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.