Back Stop: Definition, How It Works in Offering, and Example

What Is a Back Stop?

In corporate finance and investment banking, a back stop (or backstop) is to provide last-resort support or to make a bid in a securities offering for the unsubscribed portion of shares.

When a company is trying to raise capital through an issuance—and wants to guarantee the amount received through the issue—it may get a back stop from an underwriter or a major shareholder, such as an investment bank, to buy any of its unsubscribed shares.

How a Back Stop Works

A back stop functions as a form of insurance. While not an actual insurance plan, a company can guarantee that a certain amount of its offering will be purchased by particular organizations, usually investment banking firms, if the open market does not produce enough investors and a portion of the offering goes unsold.

If the organization providing the back stop is an investment banking firm, sub-underwriters representing the investment firm will enter into an agreement with the company. This agreement is referred to as a firm-commitment underwriting deal or contract, and it provides overall support for the offering by committing to purchase a specific number of unsold shares.

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 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.

Special Considerations

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. The shares are treated the same way as any other investment purchased through normal market activity. The issuing company can impose no restrictions on how the shares are traded.

The underwriting organization may subsequently hold or sell the associated securities per the regulations that govern the activity overall.

Example of a Back Stop

In a rights offering, you may see a statement to this effect: "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.