How to Calculate Distribution of Profits for the Series 7 Exam
To be successful on the Series 7 exam, you will need to understand the distribution of profits. When larger issues come to market, the lead underwriter often has to form a syndicate to help sell the securities. When selling the securities to the public, each entity receives a different portion of the selling profits.
The spread is the difference between the amount the syndicate pays the issuer when purchasing new shares or bonds and the public offering price for each share or bond sold. For example, if the syndicate buys shares from the issuer at $8.00 per share and then turns around and sells them to the public for $9.00 per share, the spread is $1.00 ($9.00 – $8.00). Naturally, you get the following formula:
So the spread is just the initial profit from selling the security; you still have to divvy it up among the salespeople. The syndicate splits the spread into the manager’s fee and the takedown, so you get the following equation:
Here’s what you need to know about the manager’s fee and the takedown:
Takedown: The takedown is the profit that each syndicate member makes when selling shares or bonds to the public. Remember that the syndicate members are the ones taking the financial risk and therefore deserve the lion’s share of the sale’s proceeds.
You can use the spread formula (spread = syndicate manager’s fee + takedown) to calculate this value, rearranging the terms like this: takedown = spread – syndicate manager’s fee. For example, if the spread is $1.00 and the manager’s fee is $0.15, the takedown is $0.85 ($1.00 – $0.15). The takedown may be further broken down as follows:
Concession: The concession is the profit the selling group makes when selling shares or bonds to the public. Selling group members don’t front money and therefore don’t receive as much of the sale’s proceeds as syndicate members. The concession is paid out of the takedown. The profit made by syndicate members on shares or bonds sold by the selling group is called the additional takedown. Here is the formula:
Reallowance: The portion of the takedown that’s available for firms that aren’t part of the syndicate or selling group is the reallowance.
For example, assume ABC Corporation is in the process of issuing new shares. You’re a stockbroker, and one of your customers calls you up to inform you that she’s interested in purchasing shares of ABC Corporation from you, but you’re not one of the official distributors of the stock. You contact the syndicate manager, who gives you a discount off the public offering price (POP). That discount is the reallowance.
Syndicate manager’s fee: This part of the spread is the profit the syndicate manager makes on shares or bonds sold by anyone. This fee is usually the smallest of all the listed fees.
The following question tests your knowledge of distribution of profits.
Nogo Auto Corp., which specializes in fuel-efficient cars, is in the process of selling new shares of their company to the public. Nogo contacts Thor Broker-Dealer Corp. to underwrite the securities. Thor realizes that the issue is too big to underwrite by itself, so it forms a syndicate.
Nogo will receive $15.00 per share for each share issued and the public offering price will be $16.20. If the manager’s fee is $0.25 per share and the concession is $0.40 per share, what is the additional takedown?
The correct answer is Choice (A). This question is a little tricky because you have to determine the takedown (the profit syndicate members make) before you can figure out the additional takedown. The additional takedown is the profit syndicate members make on shares sold by the selling group.
The spread of $1.20 ($16.20 selling price – $15.00 to Nogo) is made up of the manager’s fee of $0.25 and the takedown of $0.95 ($1.20 spread – $0.25 manager’s fee).
If the syndicate members had sold the shares by themselves, they would have received the takedown of $0.95 per share. However, the selling group sold the shares, receiving a concession of $0.40 per share. The concession is paid out of the takedown; thus, the additional takedown is $0.55 per share ($0.95 – $0.40).