An agreement providing insurance to shares of a company that are not subscribed or a secondary source of funds if the primary funds are insufficient.

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.

A company usually forms a backstop agreement with an underwriter, investment bank, or major shareholder. This serves as a form of security offering in case public shares remain unsubscribed. The company gets the amount of capital they were looking to acquire.

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

Private equity firms buy out other firms using the Leverage Buy Out (LBO) method using debt and equity. A third party enters a backstop agreement in case the funding is insufficient.

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.