An insurance agreement that offers security to unsubscribed shares of a company or a secondary source of funds in case the primary funds fall short.
What Is a Backstop?
Backstop is a form of insurance for the unsubscribed shares of a company. It may be defined as a secondary source of funds when the primary source is insufficient to meet the company’s capital requirement.
How Does a Backstop Work?
A backstop works as a form of insurance. A company decides to release a number of its share to the public. To safeguard itself from having unsubscribed shares, it enters into a backstop agreement with an investment bank. Underwriters from the bank enter into an agreement with the company to buy all unsubscribed shares. This agreement is referred to as a firm-commitment underwriting contract. This contract makes them legally responsible for buying the company’s unsubscribed shares and providing the capital associated with the specific share.
Backstop offers a risk-mitigation plan to the company and enables it to fulfill its required capital criteria. If the shareholders buy all the shares, the contract is declared void and no further action will be performed. However, if the contract is fulfilled, the underwriter’s organization has full rights/responsibility to buy the shares and is allowed to do whatever they deem necessary. The company can add no restrictions on the shares and lose the owner’s rights.
To understand, let us take an example. Company A is looking to issue 20 shares worth Rs.25,000 each. They approach an investment bank, make a backstop agreement, and sign the firm-commitment underwriting contract. After going public, they only manage to sell 15 of their shares. The underwriter is obligated to buy the remaining five shares, raising the capital to Rs. 500,000. The company receives its required amount of capital, and the underwriter gets ownership of the shares and can sell them for profit.
There are three main types of backstop agreements used in the business world:
Underwritten Backstop
Backstop in underwriting is seen when the company wants to offer shares to the general public and goes into an agreement with an underwriter who agrees to buy all unsubscribed shares. This is the most commonly used form of backstop agreement.
Private Equity Backstop
Financial Management Backstop
Backstop is also used in daily financial management to fill in any gaps in funds where a lending backstop agreement is signed. This technique is called the revolving credit facility.