Raising money is a crucial part of a business, but raising the required funds is not always easy. There may be cases when investors may not subscribe to all the shares offered to them, or the expected source of financing may fall short. In such cases, a backstop helps them in arranging the required amount.
In today’s blog post, we will give you an overview of backstop, how it works, its types, along with an example.
What is a backstop?
A backstop is a financial agreement in which an individual, organisation or institution agrees to provide support if a target funding activity falls short of its target. The support is provided through purchasing shares, providing funds, etc. It also helps a transaction proceed when the source of funding is insufficient. The parties involved in this process are known as backstop providers. Based on the agreement, the provider may be required to contribute funds, purchase securities or fulfil other financial commitments if stated conditions are met.
This is generally useful for companies when they need certainty about raising capital. This can also be used in rights issues, mergers, and acquisitions, etc., including other transactions where the requirement of funds is necessary. But this does not guarantee that every transaction will be successful.
Types of Backstop
The different types of backstop are as follows:
- Financial Backstop: In this type of backstop, they provide only financial assistance through funds when the original funding arrangement is insufficient. This generally helps companies that are in the expansion phase and ned additional funds when the primary financial source falls short.
- Underwriting Backstop: The underwriter backstop is commonly associated with share issues and other securities. According to this agreement, the backstop agrees to buy the securities such as shares, etc. that remain unsubscribed. However, this agreement contains certain charges and has a risk of holding securities that could decline in value.
- Right Issue: A right issue backstop allows an existing shareholder to purchase additional shares in proportion to their holding, according to specific terms and conditions. But in this case, not every shareholder chooses to participate; however, it can help companies reduce the risk of falling short of their fundraising objective.
- Debt Backstop: This agreement intends to provide financial support if existing sources of debt funding become insufficient. It can be useful for managing financial uncertainties, especially during acquisitions and large capital expenditure projects.
- Liquidity Backstop: This backstop helps a company access cash when it faces a temporary shortage of cash to meet its expenses. Liquidity backstop helps organisations meet their near-term obligations without impacting their operations.
Key Features of Backstop
The key features of backstop are as follows:
- Financial Safety: Backstop offers an additional layer of financial support that covers the funding shortfall when specific conditions are met.
- Defined Agreement: To provide support, a predefined agreement is entered into by the institution that needs financial support and the backstop provider.
- Reduce Uncertainty: Companies can work in an environment of greater confidence in meeting their fundraising targets if the investor does not subscribe to the entire issue.
- Include Additional Charges: The backstop providers may charge additional fees in the form of a commitment fee to provide financial assistance.
How Does a Backstop Work
The backstop works in the following manner:
- Identifying the Requirement of Funds: The company’s first step is to identify the need for capital for activities such as business expansion, debt repayment, or acquisition, etc.
- Signing a Backstop Agreement: The next step is for the company to agree on a financial instrument, investor, etc. The agreement between the company and the backstop provides specifications for the amount of support, applicable fees, timelines, and conditions.
- Start the Fund Raising Process: Initially, the company proceeds with its original fundraising plan, including issuing shares, going for a rights issue, etc.
- Identification of Shortfall: After the required fundraising period ends, the company calculates whether it has raised the required amount or has a shortfall of funds.
- Going with Backstop: If the agreement conditions are satisfied, the backstop will provide the shortfall of funds. This process may involve purchasing unsubscribed shares, providing additional funds, etc.
- Completing the Transaction: Because of additional support by the backstoppers, the company may be able to meet its target funding and can proceed with planned activities.
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Example of Backstop
Let’s understand the backstop through an example.
There is a company named ABC Limited that wants to raise 100 crore in order to establish another manufacturing unit. For this, the company decided to go for a rights issue. The company expects its shareholders who already hold shares to subscribe to the shares offered to them; however, there may be certain shareholders who do not participate in this rights issue.
To reduce this uncertainty, the company enters into a backstop agreement with a financial institution that agrees to subscribe to the shares if the fundraising target is not met. Now let’s see how the fundraising works.
| Particulars | Amount |
|---|---|
| Total Target of Fundraising | INR 100 Crore |
| Amount Subscribed by the Existing Shareholders | INR 80 Crore |
| Unfunded Amount | INR 20 Crore |
| Amount Subscribed by Backstop Institution | INR 20 Crore |
| Total Raised Fund | INR 100 Crore |
Hence, with the backstop, the company successfully raised INR 100 Crore.
Benefits of Backstop
The key benefits of a backstop are as follows:
- Certainty in Funding: The key benefit of a backstop is that it provides greater confidence about fund availability. The companies can plan their business activities with they have a backup plan.
- Reducing Risk: There are times when companies are unable to raise the full amount that they expect from investors. It can help the company cover the remaining amount and reduce the risk of falling short of funds.
- Building Investor Confidence: The commitments by the backstop may reassure investors that a company has an arrangement in place to address a potential funding shortfall.
Limitations of Backstop
The key limitations of a backstop are as follows:
- Additional Cost: A backstop provider may charge various types of fees such as commitment fees, underwriting fees, and other charges, etc. These types of expenses can increase the overall cost of raising capital.
- Do Not Guarantee Success: A backstop only provides required funding at the time of shortfall; however, it does not guarantee profitability and success of the business. The other risks, such as operational and financial risk, remain the same.
- Restrictions: The agreement between the backstop and the company might contain certain conditions under which the agreement comes into effect.
Difference between Backstop vs Underwriters
The key differences between backstop and underwriters are as follows:
| Particulars | Backstop | Underwriters |
|---|---|---|
| Overview | It is an agreement that covers funding shortfalls and provides financial assistance to companies. | Underwriters are financial institution that manages the issuance and distribution of securities. |
| Objective | Its key objective is to provide additional certainty that a specific funding target can be met. | This facilitates the issuance and sale of securities to investors. |
| Fees | It involves fees such as a commitment fee or other charges. | This may involve fees including underwriting fees or a spread on the securities issued. |
| Application | This is generally applicable when a specified funding shortfall. | This is a continuous process during the issuance of securities. |
Tax Consideration for Backstop
The tax treatment for different parties is as follows:
| Party | Tax Treatment |
|---|---|
| Backstop Provider | This fee is generally taxable as business income under the applicable rules. |
| On acquisition of unsubscribed shares | Acquired shares are generally treated as capital assets, and on subsequent sale, applicable capital gains tax may apply. |
| Issuing Company | They raised the funds through the share offering, which includes the subscribed amount provided by the backstop, and it is generally not treated as income. |
| Exercising rights by existing shareholders | Subscribing shares through a rights issue does not generate any capital gain. It is applicable only when the shares are sold. |
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Conclusion
In conclusion, a backstop is a financial safety net that allows a company to manage a shortfall of funds in important financial transactions. This involves rights issues, securities offerings, etc. In such cases, there may be uncertainties related to the risk of falling short of the intended target. A backstop helps the company raise the shortfall amount. However, for their subscription, they charge fees, including additional costs, contractual conditions, etc. This is an important financial tool for the company; understanding how it works allows an investor to make informed investment decisions.
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Frequently Asked Questions (FAQs)
What is the meaning of backstop?
A backstop is an agreement between the financial institution and a company in which it covers the funding shortfall when its initial fundraising process does not raise enough money. In such a case, the financial institution acts as a backup plan to raise money.
Name the different types of backstops?
The different types of backstops include financial backstops, underwriting backstops, debt backstops, etc.
Is there any fee charged by the backstop?
Yes, the backstop provider charges a fee in the form of a backstop fee or commitment fee to provide financial assistance.
When does the backstop agreement expire?
The backstop agreement generally expires after a specific validity period, or it can be voluntarily terminated by either party depending on the agreement conditions.
Who provides the backstop?
The backstop is provided by investment banks, financial institutions, institutional investors, shareholders, etc.
