Understanding Backstop

A backstop refers to a form of insurance or secondary source of funds that supports unsubscribed shares of a company.

It safeguards to ensure the company’s capital requirements are met when the primary funding source falls short.

Companies typically enter backstop agreements with underwriters, investment banks, or significant shareholders.

These agreements offer security if public shares are left unsubscribed, enabling the company to obtain the desired capital.

Understanding Backstop
What is Backstop? | Source: Wall Street Mojo

How Does a Backstop Work?

A backstop functions as a type of insurance mechanism.

When a company decides to release shares to the public, it enters into a backstop agreement with an investment bank.

Underwriters from the bank commit to purchasing unsubscribed shares through a firm-commitment underwriting contract.

This legally binds them to acquire the company’s unsubscribed shares and provide the associated capital.

By having a backstop in place, the company mitigates the risk of having unsubscribed shares and ensures it meets its required capital criteria.

If shareholders purchase all the shares, the backstop agreement becomes void, and no further action is taken.

However, if the agreement is fulfilled, the underwriter or their organization has the right and responsibility to purchase the shares and may dispose of them as they see fit.

The company has no control or restrictions over the shares and loses ownership rights.

There are three primary types of backstop agreements:

  1. Underwritten Backstop: This is the most common form, where the company seeks to offer shares to the general public and agrees with an underwriter who commits to purchasing any unsubscribed shares.
  2. Private Equity Backstop: In this scenario, private equity firms acquire other companies through leveraged buyouts (LBOs), which involve a combination of debt and equity. A third party may enter a backstop agreement to provide additional funds if the financing falls short.
  3. Financial Management Backstop: Backstops are also used in day-to-day financial management to bridge funding gaps. Lending backstop agreements, such as revolving credit facilities, are signed to ensure sufficient funds are available when needed.