Before we go ahead and take a dive into the world of unsubscribed shares and backstop, let us take a quick look into the kinds of shares in the stocks and investment industry, specifically the authorized, issued, subscribed, and unsubscribed shares.
1. Authorised Share Capital
It refers to the total capital accepted by a company from the investors by selling shares to them. These are mentioned in the company’s official documents. The Memorandum of Association (MOA) of a company indicates the amount of Authorised share.
2. Issues Share Capital
Issued shares are a subset of Authorised shares that have been sold off to the public. The act of issuing Issued shares is known as Issuance, allotment, or allocation.
3. Subscribed Capital
Subscribed capital is a subset of Issued share capital, and it denotes the number of shares that the public has bought. It is never mandatory for all the issued shares to be taken by the public.
Let us assume a company ABC is going public. It plans to issue out a total of 20,000 shares in an initial public offering (IPO), priced at Rs.100 each. Upon completion of the IPO, the public manages to take 16,000 of these shares.
Issued Shares = 20,000
Subscribed Shares = 16,000
Unsubscribed Shares = 4,000
If company ABC wants to sell out these extra shares, there is no guarantee that they will get sold out completely. To ensure that company ABC does not incur any losses from the second round of sales, it enters into a contract with some other wealthy investors or firms, XYZ to provide them with a backstop.
What is backstop?
A backstop is a financial arrangement where a secondary source of funds is created in case the primary source of funds does not meet the required needs. It can be thought of as an insurance policy for the buying party for buying unsubscribed shares, that guarantees the purchase of the remaining portion of unsubscribed shares by an underwriter or investment bank (hereby referred to as ‘providing organization’). It is also often thought of as a last-resort type of support, only in the case of transactions made on unsubscribed shares. The issuing firm (or the buying party) enters into a backstop contract with the providing organization upon making a transaction on such unsubscribed shares.
If all the shares being offered are sold off to the public through regular vehicles of investment, the contract obligating the providing organization to purchase any unsold shares is rendered void, as the conditions surrounding the promise to purchase no longer exist.
In the industry of stocks and investments, the term backstop refers to the last form of support offered for unsubscribed shares or securities that are offered in the sale of unsubscribed shares. Unsubscribed shares, as mentioned above, are those shares that are left unissued. Companies and investors (buying party) that are willing to invest in such shares can request a backstop from the providing organization prior to making the purchase. The reverse is also possible, i.e., if the issuing company wishes to sell them, they can get a backstop from the providing organization. The backstop provides a guarantee of payment for any unsold shares.
How does a backstop work?
Let us assume that a company wants to raise more funds, and to do so is offering its unsubscribed shares to the public. Then the company goes to an underwriter or an investment bank (providing organization) to get a backstop for the said shares. If a portion of these unsubscribed shares is not taken up by the public, then the providing organization is obliged to buy these remaining shares.
Let us take the above example further. We have 4,000 unsubscribed shares of Rs.100 each. Due to a lack of funds, the company is willing to sell these unsubscribed shares to the public. So, the company goes to a providing organization and enters into a backstop contract with them. Any risk involved in the sale of these shares is taken up entirely by the providing organization.
Out of these 4,000 shares, 3,000 were sold off to the public, and the remaining 1,000 shares valuating to Rs. 1 lakh is purchased by the providing organization.
Any number of shares purchased by the providing organization under the backstop contract is owned and managed by the providing organization. Once the providing organization has purchased the unsold backstop shares, the issuing firm loses all claims to the ownership of those shares. The issuing company can impose no restrictions on how these shares are treated. The providing organization has total control over these shares and can treat or trade these shares as they see fit as per the regulations that govern the activity overall.
A backstop can take different forms depending on the context. Below are the three possible forms it usually exists in.
1. Backstop in underwriting
This is the most common form of backstop and is seen in the case of underwriting of issued shares, during an IPO. The purpose of an IPO is to raise funds by selling its shares to the public. The underwriter gives provision for backstop under which the underwriting organization is obligated to buy all the remainder of the shares that were not sold to the public, for a backstop fee, which is calculated as a percentage of the total number of shares.
2. Private Equity Backstop
If a private equity firm wishes to acquire another company, typically it uses the Leveraged Buyout method, under which the firm finances the purchase using debt mostly, and the remainder by equity.
In case the funding falls short, another private equity firm enters into an arrangement where it agrees to provide funding to clear up the required amount in the form of equity.
3. Backstop in Financial Management
Another form of backstop exists in a company’s daily financial management, typically as a revolving credit facility. This basically acts as a simple short-term lending arrangement in which the borrower can borrow a certain amount up to a predefined maximum, for the period of a year or less.
This revolving credit facility can be used as a backstop to fulfil any scenarios of a shortage of funds for the short-term period.
A backstop is like insurance. It guarantees in some form that a company (and its investment bank) will raise the money it intends to raise.