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Main Findings
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A back stop is a financial plan that provides an alternative source of funding in case the main source is not enough. It can be seen as a form of insurance or guarantee. - Back stops can be used in different contexts, such as underwriting, private equity, and financial management. The main purposes are to ensure the success of a securities offering, to gain a competitive advantage in a deal, and to manage payment risks and liquidity.
What is a back stop in finance?
A back stop is a financial plan that establishes an additional source of funding in the event that the main source is insufficient to cover present needs. It may also be viewed as an insurance policy against the insufficiency of a funding source. Underwriting, private equity, and financial management are just a few of the situations in which the back stop can take on varied shapes.Why do companies use back stops?
Companies use back stops for various reasons, depending on the context and the purpose of the financial arrangement. Some of the common reasons are:- To ensure that a securities offering is successful and to raise the required quantity of capital. A corporation can guarantee that any shares that remain unsold will be bought by the back stop provider by obtaining a back stop from an underwriter or a sizeable shareholder, like an investment bank. In addition to giving the issuer and investors confidence, this lowers the risk of under-subscription.
- To obtain a competitive advantage and make an offer more appealing. A private equity firm can demonstrate its commitment and confidence in employing the leveraged buyout strategy to acquire a target company by providing a full equity back stop. This may increase the stakes for other possible bidders and make the deal more enticing to the target company.
- To control payment risks and liquidity. An organization can obtain extra funding in the event of unforeseen costs or revenue shortfalls by obtaining a back stop from a lender or creditor, such as a bank or revolving credit facility. By doing this, the business may be able to preserve its solvency and stay out of default.
What is the formula for calculating the back stop fee?
The formula for calculating the back stop fee is:
Back stop fee = Back stop percentage x Issue size x Price per share
For example, suppose a company issues 1 million shares at $10 per share and gets a back stop from an investment bank for 20% of the issue size. The back stop fee is:
Back stop fee = 0.2 x 1,000,000 x 10
Back stop fee = $2,000,000
How to calculate back stop
To calculate the back stop fee, we need to know the following information:- The total amount of shares that the corporation has issued
- The quantity of shares that the public subscribed for
- How many shares are still unsold
- The cost per unit
- The back stop fee % that the underwriter and you agreed upon
The back stop fee is calculated as follows:
Back stop fee = (Number of unsold shares) x (Price per share) x (Back stop fee percentage)
For example, suppose a company issues 500 shares at $10 per share and hires an investment bank as the underwriter with a back stop fee of 5%. If the public subscribes 400 shares, then the number of unsold shares is 100. The back stop fee is:
Back stop fee = (100) x ($10) x (5%) = $50
The underwriter will pay $50 to the company and buy the remaining 100 shares.
Examples of back stop
Here are some examples of back stop in different contexts:- The U.S. government offered Citigroup support in 2008 by consenting to take losses on $306 billion of its distressed assets in return for warrants and preferred stock.
- Morgan Stanley underwrote Facebook's initial public offering in 2012 and served as a safety net for the shares that were not fully subscribed. According to reports, Morgan Stanley purchased over $2 billion worth of Facebook shares to keep the market price from dropping below the $38 offering price.
- A full equity back stop was agreed to by Blackstone Group in 2019 in exchange for the £4.8 billion acquisition of Merlin Entertainments, the company that owns Madame Tussauds and Legoland. If Blackstone was unable to obtain loan financing, it agreed to pay the full purchase price using equity.
Limitations of back stop
Back stop is not a risk-free arrangement for either party involved. Some of the limitations are:- Because a back stop depends on the underwriter to purchase the unsold shares, it may lessen the issuer's incentive to successfully market the offering. As a result of the underwriter demanding a discount for assuming the risk, it can also lead to a reduced offering price.
- A back stop puts the underwriter at risk in the market since it could wind up with a lot of shares that are hard to sell or have lost value. Additionally, there could be a reputational risk because of the possibility that there won't be enough demand for the offering.
FAQ
A "Back Stop" is a term used in finance to refer to a last-resort measure or an entity that buys up the remaining securities that have not been sold in the open market.
A "Back Stop" functions as a form of insurance, providing confidence to the market that there is a buyer for the securities being issued. The backstop purchaser agrees to buy any remaining unsold shares after the public issuance.
Companies use a "Back Stop" to ensure the success of their securities issuance. It reduces the risk of the issue failing due to a lack of buyers in the market.
The "Back Stop" provider faces the risk that the securities it is obligated to buy may decline in value. This could lead to a loss if the provider is unable to resell the securities at a profit.
Yes, the term "Back Stop" can also be used in other contexts where a last-resort measure is needed. For example, in negotiations, a "Back Stop" might refer to a fallback position or compromise that a party is willing to accept if all else fails.
