What is Backstop?

There exists several ways in which a company can raise the required amount of capital. One of the ways is going public. When a company issues shares in the open market to raise the required funds, there is no guarantee that the shares issued will be fully subscribed. The backstop guarantees financial arrangements in case of insufficient funds.

What does Backstop mean?

Essentially, the definition of a “backstop” indicates supporting or reinforcing something. A backstop in the stock market is a financial arrangement that requires setting up a secondary source of finance if the primary source of funds is insufficient to meet current needs. It is the last resort of support for fund seekers.

The backstop provider takes the risk and thus mitigates the uncertainties of fund requirements. To some extent, it is similar to an insurance policy as it covers the need of scarcity of source of funds.

It can be viewed from different contexts depending on its use.

1. The backstop is important in the day-to-day financial management of the company. It is a short-term lending facility where the borrower is allowed to borrow a particular amount up to an extent for a definite shorter period, use it, and repay it.

   For example, ABC company faces a shortage of Rs. 1,00,000 in the year 2021-22. The company can use the backstop facility as a secondary source of financing to borrow Rs. 1,00,000 and meet its obligation for the year. After that, the company needs to repay it within the given period.

2. Mostly, Backstop in the stock market is used for underwriting in the issue of shares. In this case, the underwriter provides a backstop by giving a guarantee of buying the unsubscribed portion in the issue of shares. Certain fees as a percentage of a total issue size are charged for giving the guarantee.

   Suppose, XYZ company wants to raise Rs. 500,000 from the public. It issues 5000 shares of Rs. 100 each. It enters into an agreement with an investment bank, named ABC, for the backstop. ABC guarantees to purchase an unsubscribed portion of the share. From the open market, XYZ raised Rs. 400,000 by selling 4000 shares. The remaining Rs. 100,000 will be provided by ABC against 1000 shares.

How does Backstop work?

In a Backstop, the underwriter provides the guarantee of full subscription to the issuer, by purchasing an unsubscribed portion of shares. The contract between the issuer company and backstop purchaser is known as a firm-commitment underwriting contract. The backstop purchaser is obliged to purchase the shares that are not purchased by the public, against the associated capital.

Along with the risk, the backstop providers have the ownership of shares. The issuer company loses ownership of all those shares. This means they lose the right to further treatment of the shares and can not impose any restrictions on them.

In case, if all of the offerings are purchased by open market investors and other investment vehicles, the contract between issuer and backstop provider gets void, as the condition of promise to purchase unsubscribed shares no longer exists.

Final Words

To summarise, it can be said that a backstop is a support system that helps the fund seekers to raise the intended amount of funds without a barrier. When used in underwriting, the firm can be assured of full subscription irrespective of open market activity.