What does "Back Stop" Mean?

A back stop is a guarantee between a financial institution and the company for which it issues shares. The agreement assures companies that any shares of stock left unsold during the initial public offering will be bought by the financial institution. For example, say a company decides to sell $40 million US Dollars (USD) during its IPO. If $7 million USD of the stock remains unsold after the IPO process, the financial institution underwriting the sale must purchase the $7 million USD according to the back stop agreement.

Going through an IPO is a time consuming and somewhat difficult process. Companies prefer financial institutions that offer back stop agreements to ensure they will not have large amounts of unsold shares. One problem with unsold shares after the IPO process is that these shares can result in a decrease in the company’s stock price, as the company may have to sell these shares at a discount. Current shareholders purchasing stock during the IPO will then have a loss from the stock purchase.

Under the agreement of a back drop contract, financial institutions that must purchase a company’s stock may be able to shift the shares into a current mutual fund. The financial institution may also hold the shares for a certain period of time and then sell the shares on the open market. Depending on the number shares held by the underwriter, selling shares will probably be sold at various times. Selling too many shares at one time will result in the stock price dropping, causing the financial institution to lose money from the sales.

When selecting a financial institution to underwrite an IPO, companies may decide to review the institution’s current and past back stop agreements. This information provides a look at how well the institution can sell shares through the IPO process. Underwriters who cannot drive enough sales through an IPO may not receive the best clients, as the individuals who review and grade a company’s stock tend to look at poor IPO performance with some concern.

When entering a back stop agreement, it is important to consider fees or costs associated with the contract. Underwriters may charge more fees when conducting an IPO, as they can possibly be responsible for a large portion of unsold shares. Charging an additional or higher IPO fee can help offset this possibility. The institution may also select a mix of safe and risky IPOs in order to diversify overall risk associated with back stop agreements.