2.2 Equity finance (share capital)
Equity of net assets is the residual interest of the assets of the company after deducting all its liabilities. Equity comprises the nominal share capital, share premium account, retained earnings and any other reserves.
In terms of types of shares, there are ordinary shares and preference shares. In theory, there are also deferred shares but they are very rare.
Ordinary shares are the most common type of equity capital. Ordinary shareholders usually carry one vote per share. Ordinary shareholders receive dividends if there is enough profit left over after preference shareholders have been paid their fixed dividends. When a company is wound up, ordinary shareholders have the right to the residual capital that is left over after all creditors, lenders and preference shareholders have been paid.
Preference shares used to be popular in the late nineteenth and early twentieth centuries. They are much less popular these days. Many companies will only have ordinary shares. Preference shares give preference shareholders a prior right to receive a dividend, usually a fixed dividend. Preference shareholders often do not have voting rights.
Redeemable and irredeemable preference shares
Redeemable preference shares are preference shares that the company may buy back at a specific date in the future or at the shareholder’s or the company’s option. The redeemable preference shares will then be cancelled and the shareholders repaid. For this reason, they are more like debentures in nature. Therefore, dividend payments on redeemable preference shares are usually treated in the financial statements as an (interest) expense instead of a distribution of profit.
Irredeemable preference shares are preference shares that will not be bought back by the company. Irredeemable preference shares (also called participating preference shares) remain in existence like ordinary shares and may carry voting rights if this is stipulated in the company’s constitution, although in the UK this is not very common.
Dividends and capital maintenance
Having sold shares to raise capital, the law requires that this capital not be reduced or distributed to the shareholders in unauthorised ways. Capital maintenance requirements are intended to protect creditors and lenders.
Dividends can only be paid if declared and authorised in accordance with the Articles of Association. Also, the Companies Act 2006 stipulates that a company must not pay dividend out of its share capital. A ‘company may only pay dividends out of profits available for the purpose’ (Companies Act 2006), that is, out of retained earnings.
In general, directors recommend the payment of a dividend and the company declares the dividend by passing an ordinary resolution in the AGM.
‘Distributable profits’ means accumulated, realised profits less accumulated realised losses (in so far as not utilised already). To calculate the amount of distributable profits, the Companies Act 2006 stipulates that ‘relevant accounts’ must be used. Relevant accounts are compiled using either New UK GAAP or EU adopted IFRS, and will usually be audited accounts. A private limited company may be exempt from an external audit owing to its small size.
Increasing share capital
Companies can increase their share capital in the following three ways.
- Secondary public offering. Issuing new shares to the public. Shares can be issued at a nominal value or par value but they are often sold at a premium. Secondary public offerings are only available to public limited companies. Private limited companies are not allowed to offer their shares to the public.
- Rights issue. This involves the offer of new shares to existing shareholders in proportion to their existing shareholding. This method is available to both private and public limited companies. For a public limited company, a rights issue to existing shareholders may have a greater chance of success than a secondary public offering. It is also cheaper in terms of issue and administration costs.
- Bonus issue. A bonus issue (also called capitalisation issue or scrip issue) is an issue of fully paid shares to existing shareholders free of charge, also in proportion to their existing shareholding. This method is available to both private and public limited companies. A bonus issue may take the place of dividends if a company lacks the cash to pay cash dividends. Therefore, a bonus issue amounts to a stock dividend. It is funded from the company’s reserves. This involves transferring a part of the company’s reserves to its share capital. It is simply a rearrangement within the company’s equity. The company does not receive any cash from a bonus issue. In many countries this is one of the few purposes for which the share premium account may be used.
Activity 4 The Body Shop bonus share issue
The purpose of this activity is to understand how companies might use bonus issues using the example of The Body Shop in 1984.
The Body Shop had a share capital of £100 between 1976 and March 1984. On 1 March 1984:
- The authorised share capital of the company was increased to £51,000. This meant that the company was allowed to issue up to £51,000 in share capital.
- Each £1 ordinary share was then divided into 20 ordinary shares of £0.05 each.
- A bonus issue (scrip issue) of 1,000,000 ordinary shares was made on the basis of 500 ordinary £0.05 shares for each ordinary share in issue (The Body Shop International plc, 1984).
Anita held 25% of the shares, Gordon held 25% of the shares, and a third shareholder held 50% of the shares.
What was the consequence of this bonus issue for the three shareholders of The Body Shop?
Although the authorised share capital increased from £100 to £51,000, the issued share capital increased from £100 to £100 + £50,000 = £50,100.
Each £1 ordinary share was then divided into 20 ordinary shares of £0.05 each. This means that instead of 100 shares of £ each, there were now 100 × 20 = 2,000 shares of £0.05 each.
A bonus issue (scrip issue) of 1,000,000 ordinary shares was made on the basis of 500 ordinary £0.05 shares for each ordinary share in issue. In other words, 2,000 shares × 500 = 1,000,000 shares × £0.05 amounted to an increase in share capital of £50,000.
- Anita’s shareholding increased from £25 to £25 + £12,500 = £12,525
- Gordon’s shareholding increased from £25 to £25 + £12,500 = £12,525
- The third shareholder’s shareholding increased from £50 to £50+ £25,000 = £25,050