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How IPOs Could Work

In the typical underwriting, the underwriter (investment bank) gets 7% of the value of the issue as its fee. Nowadays, that 7% is usually paid in cash, while in the old days, the underwriter often got 7% of the actual shares.

The trick, therefore, is for the underwriter to price the issue to sell at least the 93% of the issue being offered directly by the company. As the underwriter, the investment bank is supposed to make up the difference, by either selling shares from its 7%, or by buying the portion of the 93% that the market couldn't absorb.

The 7% fee is large, but not unreasonable, given the not inconsiderable level of risk. But as a practical matter, the underwriter will seldom lose on the deal, because gains on the "free" 7% will likely more offset losses elsewhere. And the underwriter is being paid to absorb the (rare) losses from sloppy underwriting, or just plain bad luck; e.g. "Black Monday." 

Even so, the fee is one that is tight enough to hold underwriters to a very high standard. Unfortunately, few firms nowadays are capable of meeting that standard.