Decisions relating to the raising of equity are a key aspect of corporate finance.
Equity shareholders are the owners of the business and exercise ultimate control, through their voting rights.
The term equity relates to ordinary shares only.
Equity finance is the investment in a company by the ordinary shareholders, represented by the issued ordinary share capital plus reserves.
There are other types of share capital relating to various types of preference share. These are not considered part of equity, as their characteristics bear more resemblance to debt finance
Different types of equity finance
The main options for companies wishing to raise equity finance are:
Internally-generated funds are earnings retained in the business (i.e. undistributed profits attributable to ordinary shareholders).
For an established company, internally-generated funds can represent the single most important source of finance, for both short and long-term purposes.
Such finance is cheap and quick to raise, requiring no transaction costs, professional assistance or time delay.
Retained earnings are also a continual source of new funds, provided that the company is profitable and profits are not all paid out as dividends.
Of course, for major investment projects, a greater amount of equity finance may be required than that available from internal sources
Rights issues A rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the current market value, in proportion to their existing holdings.
This option is the simplest method, providing the existing shareholders can afford to invest the amount of funds required. The existing shareholders' control is not diluted.
Public issue A public offer is an invitation to apply for shares in a company based upon information contained in a prospectus, either at a fixed price or by tender.
Gaining a public listing increases the marketability of the company's shares, and makes it easier to raise further equity finance from a large number of investors in the future.
Becoming a listed company is an expensive and time-consuming process, and once listed, the company has to face a higher level of regulation and public scrutiny. Also, since the company's shares are likely to become widely distributed between many investors, the threat of takeover increases when a company becomes listed.
"Private equity finance" is the name given to finance raised from investors organised through the mediation of a venture capital company or private equity business. These investors do not operate through the formal equity market, so raising private equity finance does not expose the company to the same level of scrutiny and regulation that a stock market listing would.
Private equity is often perceived as a relatively high risk investment, so investors usually demand higher rates of return than they would from a stock market listed company. Business Angels are a source of private equity finance for small companies.
New share issues
There are several methods of issuing new shares, depending on the circumstances of the company:
Choosing between sources of equity
Accessibility to finance
The ability of a company to raise equity finance is restricted by its access to the general market for funds. Thus, whilst quoted companies are able to use any of the sources, an unquoted company is restricted to rights issues and private placings. The problem of equity finance for smaller companies is examined here.
Furthermore, there are statutory restrictions, e.g. those in the UK imposed by the Companies Act 1985. Only public limited companies may offer shares to the general public.
Obviously, the need to raise finance could be combined with a flotation (i.e. a private company going public and having its shares quoted on a recognised stock exchange). However, flotations will incur significant costs.
Amount of finance
The amount of finance that can be raised by a rights issue from an unquoted company is limited by the number and resources of the existing shareholders. It is not possible to provide general estimates of the amounts that may be raised as the circumstances vary. For quoted companies, where rights may be sold, this is less problematic.
Larger sums can be raised by placings, but ultimately it is the offer of shares to the general public that opens up the full financial resources of the market.
Costs of issue procedures
Use of internally-generated funds is easily the cheapest and simplest method. For new issues, placings are the most attractive on cost grounds, followed by rights issues, with public offers being by far the most expensive.
However all new share issues will take management and administrative time within the company. This will be much greater for an offer for sale than for the other two alternatives.
Pricing of the issue
One of the most difficult problems in making a new issue to the public is setting the price correctly. If it is too high, the issue will notbe fully taken up and will be left with the underwriters, and if it is underpriced some of the benefits of the project for which the finance is being raised will accrue to the new shareholders and not to the old.
The same pricing problem exists with a placing as with a new issue. There will be no danger of undersubscription, of course, because the placing is agreed before the issue is made. However, the price will have been negotiated so as to be attractive to the subscribing institutions. Almost inevitably, it will be below the issue price thatit would obtain in the market, because of the attractions of lower issue costs.
A rights issue, on the other hand, completely by-passes the price problem. Since the shares are offered to existing shareholders, it does not matter if the price is well below the traded price. Indeed, it would be normal for this to be so. Any gain on the new shares would, by the nature of a rights issue, go to the existing shareholders.
The pricing of new issues is even more complex when the company is unquoted. A company coming to the market for the first time would have n oexisting market price to refer to and would have to value the shares from scratch.
There is no change in the shareholders with internally-generated funds and rights issues, insofar as they are taken up by existing shareholders. On the other hand, placings and sales to the general public introduce new shareholders.
Which is preferable depends on the objectives of the fund-raising exercise. If the desire is to retain control for the existing shareholders, then a rights issue is preferable. If diversification ofcontrol is desired, then an issue to the public will be preferred.
There can be no rigid rules concerning the choice of finance. Useof internally-generated funds is the best choice, subject to sufficient availability and dividend policy considerations. Of the new issue options, the order of preference will generally be a rights issue, placing and offer for sale to the general public. As funds available are consumed, so the next source is utilised.
Further detail and related topics
Cost of equity
Created at 8/21/2012 5:05 PM by System Account
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Last modified at 11/13/2012 10:46 AM by System Account
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