What Is Backstop in Stock Market: A Comprehensive Guide

In the stock market, a backstop is a financial arrangement that acts as a secondary source of funding, providing a safety net if the primary funding source falls short. It's essentially a backup plan, often used in underwriting IPOs (Initial Public Offers) or other financial transactions, to ensure that a company can raise the full amount of capital it needs.

In capital‑raising events like initial public offerings or rights issues, a backstop is a guarantee by an underwriter, institution or investor to purchase any unsubscribed shares. It acts like insurance, ensuring the issuer meets its funding goals.

Variants of Backstop

A backstop may take several forms depending on the nature of fund raising:

• Underwriting backstop occurs when underwriters agree in advance to buy any unsold shares at a fixed price. This is common in firm‑commitment underwriting.
  

• Private equity backstop involves investors promising to step in if initial funding rounds fall short, ensuring transactions proceed smoothly.
  

• Liquidity backstop takes the form of revolving credit or financing lines, providing short‑term capital if needed.

Here’s a step-by-step breakdown of how the backstop process works:

Issuer Announces the IPO or Rights Issue

The issuer announces an upcoming IPO (Initial Public Offering) or rights issue to raise capital. This involves offering a set number of shares to the public, either through a new issue of shares (IPO) or a rights issue (offering additional shares to existing shareholders).

Underwriters or Investors Agree to Backstop Unsubscribed Shares

To reduce the risk of not meeting the funding target, the issuer enters into an agreement with underwriters or investors, often called backstop providers. These parties agree to step in and purchase any unsubscribed shares from the public offering, ensuring the full amount of funds the issuer plans to raise is secured.

Fee is Negotiated

A fee is typically agreed upon for the backstop provider, which is usually a percentage of the total amount of the issue or the unsubscribed portion. This fee compensates the provider for taking on the risk of purchasing the unsold shares. It is crucial for both parties to negotiate the fee terms based on the perceived risk and the size of the issue.

Public Subscription Closes

The offering is then open to the public, where investors and existing shareholders can subscribe to the shares. Once the subscription period ends, the issuer tallies up the total number of shares subscribed to by the public.

Backstop Provider Purchases Residual Shares

If the public does not fully subscribe to the entire offering (i.e., demand falls short), the backstop provider purchases the remaining shares. The backstop provider may buy these shares at the same price as the original offering or under agreed-upon terms. This ensures that the company still raises the full amount it aimed for.

Issuer Receives Full Proceeds as Planned

By using a backstop, the issuer is guaranteed to meet its fundraising goal, regardless of the subscription rate from the public. As a result, the company can proceed with its planned financial objectives, such as paying down debt, funding expansion, or other capital needs.

Example

Here's an example of how the backstop works:

A company plans to issue 1 Crore shares in its IPO. The public subscribes to only 80 Lakh shares, leaving a shortfall of 20 Lakh shares. The backstop provider buys the remaining shares, ensuring the company raises the ₹20 Crores it aimed for. This guarantees full funding, providing stability to the issuer and confidence to investors.

• Underwriting Backstop

  An underwriter agrees to purchase any unsubscribed shares in an issue, ensuring the company raises the planned capital.

• Private Equity Backstop
  In acquisitions or buyouts, a private equity firm may provide funds if debt financing falls short, helping complete the transaction.

• Financial Management Backstop
  Companies may use tools like revolving credit facilities as a fallback to cover short-term cash flow gaps.

A backstop offers valuable advantages:

• Capital certainty: Issuers secure full funding as planned.
  

• Investor confidence: Signals to the market that institutional players endorse the issue.
  

• Pricing stability: Reduces volatility and uncertainty around share prices.
  

It is important to note:

• Fee burden: Issuers pay higher fees to the backstop provider, impacting overall cost.
  

• Risk transfer: The provider assumes risk on unsubscribed shares.
  

• Strategic impact: May affect how the offering is structured or priced in advance.
  

Although both provide stability, they serve different purposes:

Knowing about backstops helps investors and market watchers:

• For issuers: Ensures fundraising objectives are secured.
  

• For investors: Backstop presence often indicates greater credibility and reduced risk.
  

A backstop arrangement gives assurance that capital‑raising rounds will not fall short. Whether during IPOs, rights issues or private funding, it offers a safety net that stabilises outcomes and nurtures investor faith.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.