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What Is a Back Stop And How It Is Useful

24 Aug 2023

Introduction:

Every company, irrespective of its nature and size, requires funding at regular intervals. There are several ways through which a company can raise the capital needed. One such way is to sell equity shares to the public. When a company sells its equity shares to the public for the first time, it is known as an Initial Public Offering (IPO).

An IPO can help a company raise the required funds for its expansion and meet working capital requirements. For example, if a company plans to sell 50 lakh equity shares at an upper price band of Rs. 500 per share, it can raise approximately Rs. 250 crores. But what if the funds raised are insufficient or the issue remains undersubscribed?

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This is where a back stop arrangement comes to the issuing company’s rescue. This article discusses the backstop and how it works in the equity markets. Keep reading.

What is a back stop?

A back stop is an arrangement that helps a company create a secondary source of funds as a backup for its primary source. Here, an underwriter or an investment bank – known as the providing organization – guarantees the issuing company to buy remaining equity shares if they go unsubscribed or unsold.

Thus, a back stop acts as an insurance policy for the issuing company, protecting it from losing funds due to unsubscribed or undersubscribed shares. A back stop can also be seen as a last-resort support to the issuing company in case its equity shares remain unsubscribed. The issuing company can enter a back stop contract with the providing organisation before releasing its offer to sell equity shares.

In case all the shares offered by the issuing company get sold or subscribed by investors, the backstop contract – obligating the providing organisation to purchase unsubscribed shares – stands void.

Importance of a backstop

As mentioned, a back stop agreement works like an insurance policy for the issuing company. It protects them from the risks associated with a public issue and uncertainties around the requirement of funds. Depending on the particular scenario, it can provide different benefits to the company. For instance,

  • Helps in meeting day-to-day financial requirements

A back-stop arrangement helps a company meet its day-to-day financial requirements. It allows them to borrow short-term loans from the providing organisation, use them for various purposes, and repay. For example, if a company, XYZ faces a Rs. 1 crore shortage even after issuing its IPO, it can use the back stop facility to borrow this amount from the providing organization and meet its financial obligations.

  • A crucial function of an underwriter

Offering a back stop facility is one of the most crucial functions of underwriters. When a company plans to issue its IPO, it hires the services of an underwriter. This underwriter analyses the company’s financial requirements and decides on the important details of the IPO, such as the number of equity shares that should be sold, the price of each share, etc It also guarantees the required capital through a backstop contract. In return, the underwriter takes a fee from the issuing company.

For example, suppose a company, ABC, wants to raise Rs. 50 lakhs through a public issue. It approaches an investment bank and hires it as the underwriter for the issue. The bank., in turn, advises the company to issue 50,000 equity shares of Rs. 100 each. It also provided the guarantee of capital through a back stop arrangement.

However, ABC could sell only 40,000 shares to raise Rs. 40 lakhs. So, in this case, the underwriter will have to buy the remaining 10,000 shares from the company for Rs. 10 lakhs.

To sum it up

As you know, in a back stop arrangement, an underwriter provides a guarantee of full subscription to the issuing company. If the subscription remains undersubscribed, the underwriter must purchase the remaining shares from the issuing company at the issue price. After this, the underwriter will become a rightful shareholder in the company.

So, while a back stop helps the issuing company mitigate risks, it entails some risk for the underwriter. But at the same time, the underwriter can enjoy ownership rights in the issuing company and even make crucial business decisions. But a backstop contract becomes void if the public issue gets fully subscribed or oversubscribed.

As an investor, you can subscribe to the latest IPOs to make decent listing gains. If you need a Demat account to invest in IPOs, you can open it for free with Motilal Oswal.

 

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