Equity financing is the method of raising capital by selling company stock to investors. In return for the investment, the shareholders receive ownership interests in the company.
How it works (Example):
In order to grow, a company will face the need for additional capital, which it may try to obtain in one of two ways: debt or equity. Equity financing involves the sale of the company’s stock and giving a portion of the ownership of the company to investors in exchange for cash. The proportion of the company that will be sold in an equity financing depends on how much the owner has invested in the company and what that investment is worth at the time of the financing. For example, an entrepreneur who invests $600,000 in the startup of a company will initially own all of the shares of the company.
As the company grows and requires further capital, the entrepreneur may seek an outside investor, such as an angel investor or a venture capitalist, two main sources of early stage equity financing. If, in this example, the investor is willing to pay $400,000 and agrees to a share price of $1.00 (i.e. that the original $600,000 invested is still worth $600,000), then the total capital in the company will be raised to $1,000,000. The entrepreneur will then control 60% of the shares of the company, having sold 40% of the shares of the company to the investor through an equity financing.
Why it Matters:
During the early stages of a company’s growth, particularly when the company does not have sufficient revenues, cash flow or hard assets to act as collateral, equity financing can attract capital from early stage investors who are willing to take risks along with the entrepreneur.
Similarly, when a company is established and has assets and cash flow or has the promise of explosive growth due to new technologies or new markets, it can raise substantial capital through an equity financing such as a public offering in the capital markets. Based on the company’s share price, a portion of the company is sold to the new investors. For the entrepreneur, equity financing is a method to raise capital for the company before it is profitable in exchange for diluted ownership and control of the company.
For investors, equity financing is an important method of acquiring ownership interests in companies. Investors are always wary that subsequent rounds of equity financing usually require them to dilute some portion of their ownership as well.
Preference shares are those shares which carry certain special or priority rights. Firstly, dividend at a fixed rate is payable on these shares before any dividend is paid on equity shares.
Secondly, at the time of winding up of the company, capital is repaid to preference shareholders prior to the return of equity capital. Preference shares do not carry voting rights. However, holders of preference shares may claim voting rights if the dividends are not paid for two years or more on cumulative preference shares and three years or more on non-cumulative preference shares.
Preference shares have the characteristics of both equity shares and debentures. Like equity shares, dividend on preference shares is payable only when there are profits and at the discretion of the Board of Directors.
Preference shares are similar to debentures in the sense that the rate of dividend is fixed and preference shareholders do not generally enjoy voting rights. Therefore, preference shares are a hybrid form of financing.
- Appeal to Cautious Investors:
Preference shares can be easily sold to investors who prefer reasonable safety of their capital and want a regular and fixed return on it.
- No Obligation for Dividends:
A company is not bound to pay dividend on preference shares if its profits in a particular year are insufficient. It can postpone the dividend in case of cumulative preference shares also. No fixed burden is created on its finances.
- No Interference:
Generally, preference shares do not carry voting rights. Therefore, a company can raise capital without dilution of control. Equity shareholders retain exclusive control over the company.
- Trading on Equity:
The rate of dividend on preference shares is fixed. Therefore, with the rise in its earnings, the company can provide the benefits of trading on equity to the equity shareholders.
- No Charge on Assets:
Preference shares do not create any mortgage or charge on the assets of the company. The company can keep its fixed assets free for raising loans in future.
A company can issue redeemable preference shares for a fixed period. The capital can be repaid when it is no longer required in business. There is no danger of over-capitalisation and the capital structure remains elastic.
Different types of preference shares can be issued depending on the needs of investors. Participating preference shares or convertible preference shares may be issued to attract bold and enterprising investors.
Preference shares can be made more popular by giving special rights and privileges such as voting rights, right of conversion into equity shares, right of shares in profits and redemption at a premium.
- Fixed Obligation:
Dividend on preference shares has to be paid at a fixed rate and before any dividend is paid on equity shares. The burden is greater in case of cumulative preference shares on which accumulated arrears of dividend have to be paid.
- Limited Appeal:
Bold investors do not like preference shares. Cautious and conservative investors prefer debentures and government securities. In order to attract sufficient investors, a company may have to offer a higher rate of dividend on preference shares.
- Low Return:
When the earnings of the company are high, fixed dividend on preference shares becomes unattractive. Preference shareholders generally do not have the right to participate in the prosperity of the company.
- No Voting Rights:
Preference shares generally do not carry voting rights. As a result, preference shareholders are helpless and have no say in the management and control of the company.
- Fear of Redemption:
The holders of redeemable preference shares might have contributed finance when the company was badly in need of funds. But the company may refund their money whenever the money market is favourable. Despite the fact that they stood by the company in its hour of need, they are shown the door unceremoniously.
Equity shares are the main source of finance of a firm. It is issued to the general public. Equity shareholders do not enjoy any preferential rights with regard to repayment of capital and dividend. They are entitled to residual income of the company, but they enjoy the right to control the affairs of the business and all the shareholders collectively are the owners of the company.
Features of Equity Shares
- They are permanent in nature.
- Equity shareholders are the actual owners of the company and they bear the highest risk.
- Equity shares are transferable, i.e. ownership of equity shares can be transferred with or without consideration to other person.
- Dividend payable to equity shareholders is an appropriation of profit.
- Equity shareholders do not get fixed rate of dividend.
- Equity shareholders have the right to control the affairs of the company.
- The liability of equity shareholders is limited to the extent of their investment.
Advantages of Equity Shares
Equity shares are amongst the most important sources of capital and have certain advantages which are mentioned below:
- Advantages from the Shareholders’ Point of View
(a) Equity shares are very liquid and can be easily sold in the capital market.
(b) In case of high profit, they get dividend at higher rate.
(c) Equity shareholders have the right to control the management of the company.
(d) The equity shareholders get benefit in two ways, yearly dividend and appreciation in the value of their investment.
- Advantages from the Company’s Point of View:
(a) They are a permanent source of capital and as such; do not involve any repayment liability.
(b) They do not have any obligation regarding payment of dividend.
(c) Larger equity capital base increases the creditworthiness of the company among the creditors and investors.
Disadvantages of Equity Shares:
Despite their many advantages, equity shares suffer from certain limitations. These are:
- Disadvantages from the Shareholders’ Point of View:
(a) Equity shareholders get dividend only if there remains any profit after paying debenture interest, tax and preference dividend. Thus, getting dividend on equity shares is uncertain every year.
(b) Equity shareholders are scattered and unorganized, and hence they are unable to exercise any effective control over the affairs of the company.
(c) Equity shareholders bear the highest degree of risk of the company.
(d) Market price of equity shares fluctuate very widely which, in most occasions, erode the value of investment.
(e) Issue of fresh shares reduces the earnings of existing shareholders.
- Disadvantage from the Company’s Point of View:
(a) Cost of equity is the highest among all the sources of finance.
(b) Payment of dividend on equity shares is not tax deductible expenditure.
(c) As compared to other sources of finance, issue of equity shares involves higher floatation expenses of brokerage, underwriting commission, etc.
Different Types of Equity Issues:
Equity shares are the main source of long-term finance of a joint stock company. It is issued by the company to the general public. Equity shares may be issued by a company in different ways but in all cases the actual cash inflow may not arise (like bonus issue).
The different types of equity issues have been discussed below:
- New Issue:
A company issues a prospectus inviting the general public to subscribe its shares. Generally, in case of new issues, money is collected by the company in more than one installment— known as allotment and calls. The prospectus contains details regarding the date of payment and amount of money payable on such allotment and calls. A company can offer to the public up to its authorized capital. Right issue requires the filing of prospectus with the Registrar of Companies and with the Securities and Exchange Board of India (SEBI) through eligible registered merchant bankers.
- Bonus Issue:
Bonus in the general sense means getting something extra in addition to normal. In business, bonus shares are the shares issued free of cost, by a company to its existing shareholders. As per SEBI guidelines, if a company has sufficient profits/reserves it can issue bonus shares to its existing shareholders in proportion to the number of equity shares held out of accumulated profits/ reserves in order to capitalize the profit/reserves. Bonus shares can be issued only if the Articles of Association of the company permits it to do so.
- Advantage of Bonus Issues:
From the company’s point of view, as bonus issues do not involve any outflow of cash, it will not affect the liquidity position of the company. Shareholders, on the other hand, get bonus shares free of cost; their stake in the company increases.
- Disadvantages of Bonus Issues:
Issue of bonus shares decreases the existing rate of return and thereby reduces the market price of shares of the company. The issue of bonus shares decreases the earnings per share.
iii. Rights Issue:
According to Section 81 of The Company’s Act, 1956, rights issue is the subsequent issue of shares by an existing company to its existing shareholders in proportion to their holding. Right shares can be issued by a company only if the Articles of Association of the company permits. Rights shares are generally offered to the existing shareholders at a price below the current market price, i.e. at a concessional rate, and they have the options either to exercise the right or to sell the right to another person. Issue of rights shares is governed by the guidelines of SEBI and the central government.
Rights shares provide some monetary benefits to the existing shareholders as they get shares at a concessional rate—this is known as value of right which can be computed as:
Value of right = Cum right market price of a share – Issue price of a new share / Number of old shares + 1
- Advantages of Rights Issue:
Rights issues do not affect the controlling power of existing shareholders. Floatation costs, brokerage and commission expenses are not incurred by the company unlike in the public issue. Shareholders get some monetary benefits as shares are issued to them at concessional rates.
- Disadvantages of Rights Issue:
If a shareholder fails to exercise his rights within the stipulated time, his wealth will decline. The company loses cash as shares are issued at concessional rate.
- Sweat Issue:
According to Section 79A of The Company’s Act, 1956, shares issued by a company to its employees or directors at a discount or for consideration other than cash are known as sweat issue. The purpose of sweat issue is to retain the intellectual property and knowhow of the company. Sweat issue can be made if it is authorized in a general meeting by special resolution. It is also governed by Issue of Sweet Equity Regulations, 2002, of the SEBI.
- Advantages of Sweat Issue:
Sweat equity shares cannot be transferred within 3 years from the date of their allotment. It does not involve floatation costs and brokerage.
- Disadvantage of Sweat Issue:
As sweat equity shares are issued at concessional rates, the company loses financially.