1 Understanding equity issues
1.1 Equity instruments
Both public and private incorporated companies can issue shares in order to finance their operations. Those who invest in shares expect a return blended from dividend yield and capital growth – although the expectations of investors vary from country to country. In the USA, for example, many companies rarely, if ever, pay dividends, with the result that investors seek their returns through share price growth. You will have learnt from earlier finance studies that investors require higher returns from those companies deemed to have greater financial and operational risks. Additionally, you would have learnt that the required return on a share can be estimated using the capital asset pricing model (CAPM) or dividend valuation models.
Shares may take the following forms:
Ordinary shares: these give the shareholders ownership of the company and entitlement to a share of the business after the creditors – including bondholders and the banks – have been paid. Ordinary shareholders have voting rights but no automatic entitlement to dividend earnings. Ordinary shareholders (known as common stockholders in the USA) stand behind preference shareholders (known as preferred stockholders in the USA) when it comes to the payment of dividends.
Preference shares: these also give the shareholders ownership of the company. Like ordinary shareholders, preference shareholders cannot put the company into liquidation if a dividend is not paid. The rate of the dividend on preference shares is usually fixed and, as noted above, is payable before an ordinary share dividend can be paid. Most preference shares are cumulative. This means that all back payments of dividends on preference shares (if overdue) have to be paid before an ordinary share dividend can be paid. Preference shareholders usually only have voting rights in the event of a major issue affecting the company, such as an alteration of its capital structure.
Additionally, some companies issue share warrants. These are options that give the holder the right of exercise to obtain shares at defined strike prices.
Shares have a nominal value (or par value) as well as a market value. What is the difference between the two?
The nominal or par value of a share is the minimum price at which it may be issued. This represents the share capital in a company's balance sheet. If shares are issued above the par value the difference is termed the share premium and this is placed in the share premium account.
The market value of shares is the price at which they may be currently bought or sold in the market. To be prudent you should value shares you currently own at the ‘bid’ price on the exchange, since that is the price you would get if you sold them. The bid-to-offer spread for shares is normally small (e.g. a few pence on the London Stock Exchange) for shares in major companies where liquidity is good. For smaller companies (where there is less trade in their shares) the bid-to-offer spread is much wider.
There is no need for the market value of a share to be close to its nominal or par value. For example, a 25p share can trade at £10. If the share is trading below 25p, however, new shares cannot be issued below the par value.
There are international differences. In the USA the nominal value of a share is normally higher than in the UK. Also, in the USA and other countries, but not in the UK, there are shares of ‘no par value’. This allows shares to be issued at any price, with no minimum price being prescribed.
When new private companies issue shares, a major target group of investors, apart from the founders of the company and its management, are venture capital companies. Since the 1980s, venture capital has become a widely used source of finance for companies. Venture capital companies are suppliers of private equity finance to new or recently formed companies (note though that there is more than one definition of a venture capital company internationally). In the UK, venture capital companies invested £62 billion in 26,000 companies worldwide between 1984 and 2005.
As the company grows and establishes a track record of performance, a point may be reached where it needs more finance to support the development of the business. Additionally, a point is often reached where the founders of the company and those other investors who have provided the initial private equity want to realise at least part of their investment. It is at this point that the company may go to the public equity market to raise capital. This activity is known as the initial public offering (IPO).
In the next two sections we will look at these two alternative means of raising equity finance and the factors that determine whether companies remain funded by private equity or whether they ‘go public’ through an IPO.