What is a Back Stop?
A back stop is a person or entity that purchases leftover shares from the underwriter of an equity or rights offering.
How Does a Back Stop Work?
For example, let’s assume that Company XYZ is going public. It plans to issue 10 million shares in an initial public offering. Its investment bank, Bank ABC, agrees to underwrite the IPO. Bank ABC creates a document detailing Company XYZ’s business model, financial forecasts and the terms of the offering, and it meets with several potential investors to gauge their interest in purchasing the shares. After this process, Bank ABC has agreements to sell all 10 million shares for $25 per share.
However, Bank ABC also comes to a special agreement with John Doe, a wealthy investor, who agrees to be Bank ABC’s back stop. If for some reason Bank ABC can’t sell all the shares in the IPO (this is called the unsubscribed portion), John Doe agrees to buy those leftovers. John Doe, of course, obtains a fee for agreeing to be the back stop because he is taking on the risk of having to purchase (and they trying to reissue) the Company XYZ securities.
Why Does a Back Stop Matter?
A back stop is like insurance. It guarantees in some form that a company (and its investment bank) will raise the money it intends to raise.
