What is a Back Stop?
A back stop is the act of providing last-resort support or security in a securities offering for the unsubscribed portion of shares. A company tries to raise capital through an issuance, and to guarantee the amount received through the issue, it gets a back stop from an underwriter or major shareholder (such as an investment bank) to buy any of the unsubscribed shares.
Understanding Back Stops
A back stop functions as a form of insurance. It provides an avenue to guarantee that a certain amount of the offering will be purchased by particular organizations, usually investment banking firms, if a portion of the offering goes unsold on the open market. Sub-underwriters representing the investment firm enter into an agreement referred to as a firm-commitment underwriting deal or contract.
These contracts provide overall support for the offering by committing to purchase a specific number of unsold shares. If all of the offering is purchased through regular investment vehicles, the contract obligating the organization to purchase any unsold shares is rendered void, as the conditions surrounding the promise to purchase no longer exist.
The contracts between an issuer and the underwriting organization can take various forms. For example, the underwriting organization can provide the issuer with a revolving credit loan to boost credit ratings for the issuer. Or they can issue letters of credit as guarantees to the entity raising capital through offerings.
- Back stops are used to provide support or security in a securities offering for unsubscribed shares.
- Back stops function as insurance and support for the overall offering, ensuring that the offering does not fail if all shares are not subscribed.
Back Stops as Insurance
While not an actual insurance plan, a back stop provides security through the guarantee that a particular amount of shares will be purchased if the open market does not produce enough investors. By entering into a firm-commitment underwriting agreement, the associated organization has claimed full responsibility for the quantity of shares specified if they initially go unsold, and promises to provide the associated capital in exchange for the available shares. This gives assurance to the issuer that the minimum capital can be raised regardless of the open market activity. Additionally, all risk associated with the specified shares is effectively transferred to the underwritten organization.
If the underwriting organization takes possession of any shares, as specified in the agreement, the shares belong to the organization to manage as it sees fit, and are treated the same as any other investment purchased through normal market activity. The issuing company can impose no restriction on how the shares are traded. The underwriting organization may hold or sell the associated securities per the regulations that govern the activity overall.
Example of a Back Stop
In a rights offering, you might hear "ABC Company will provide a 100 percent back stop of up to $100 million for any unsubscribed portion of the XYZ Company rights offering." If XYZ is trying to raise $200 million but only raises $100 million through investors, then ABC Company purchases the remainder.