All You Need to Know About Equity Financing
September 30, 2019
With the turn of the 18th century, it ushered us in the industrial revolution. There was a rapid expansion of capacity, coupled with the modernisation of the industrial unit to satisfying insatiable human wants.
Traditional the concept of doing business via a partnership or association no longer was a viable option and the modern concept of the joint stock company started taking shape.
Why do we require Equity Financing?
Our modern economy is based on a sound financial system which helps in production, capital and economic growth by encouraging saving habit and mobilising the non-productive capital to the productive use such as trade, commerce and manufacturing.
The traditional form of financing, companies project consists of internal resources and debt financing. These funds were procured from the big financial institution and allocated to the modernization, expansion and diversification. However, with the upsurge in the performance of a large company and an astounding increase of their share price, boosted the market sentiment to divert the saving more and more into an equity investment in companies. This resulted in the growth of equity financing not only for the big industrial companies but for a financial institution like a bank as well.
What is Equity?
The equity shares sometimes referred to as ordinary share is the portion of the nominal capital which is subscribed by the shareholder. Any business in need of the capital has to analysis the trade-off between equity and debt fund. The equity finance is more suited when the company is not looking for any fixed commitment by way of interest payment and servicing of loan or debenture.
However, the issue of equity so as to raise fund result in the dilution of the ownership base, thus reducing the earning per share (EPS). There is certain fundamental characteristic attached to equity shares which are follow;
- Equity shares has a voting right at all the general meeting.
- Equity shareholder has the right to share the profit of the company by way of dividend and bonus share. Provided the company makes the profit in the given financial year
- Right to vote on every resolution placed before the company.
- Right to receive the copy of the accounts of the company.
- Right to inspect various statutory register maintained by the company.
- Right to requisition extraordinary general meeting of the company.
- Right to receive notice of the meeting of the member.
What are the different class of instrument?
The corporate financial instruments can be classified into
- Hybrid: – Are those which combine the feature of both equity with bond, preference and equity. A good example of this type of instrument is convertible debenture.
2. Pure: – Are those in which the inherent characteristic of the investment remains intact, without mixing the quality of other instruments, like preference share, equity share and debenture.
3. Derivatives; – Derivatives are contract which derives their value from the underlying assets which it represents. The most common trade derivatives are future, forward, option and swaps.
The option which a company exercises largely depend upon the cost of capital, servicing of an instrument, debt-equity ratio, and various law pertaining to SEBI and Securities Contracts (Regulation) Act 1956.
Section 43 of the Indian Company Act 2013 permits a company limited by share to issue two class of shares;
- With voting rights or
- With differential right as to dividend, voting or otherwise in accordance with such rule as may be prescribed.
Procedure for the issue of share and grading of IPO?
Equity share is traded in the securities market. The securities market is for those financial instrument/claim/obligations that are commonly and readily transferable by sale. The securities market has two interdependent segments which are as follow;
- Primary Market
- Secondary Market
While the primary market deals with the sale of the new issue of securities, the secondary market deal in trading of securities already issued to the public.
The general working is that, a company issue the new securities in the primary market to raise initial; investment. The primary market is of great significance to our economy, it is through this market that the funds are allocated and put to productive use.
The secondary comprises of the stock exchanges where the buying and selling of the class of already issued share are undertaken. The trading activity can only be undertaken through stock exchange via a medium of a broker and trading of securities is confined only to stock exchanges.
Secondary market along with the primary market are an essential indicator of performance and health of the economy. The strength of the economy can be gauged by the activities of the Stock Exchanges. The issue of equity is regulated by the SEBI and Securities Contracts (Regulation) Act 1956.
The equally important aspect of equity finance is the grading of the IPO. The main aim is to facilitate the assessment of the equity share being offered to the public. The grading is done in relation to the universe of other listed equity securities in India. The grading is assigned on a five-point scale with a higher score indicating stronger fundamentals.
As per the SEBI(ICDR) Regulation, every unlisted company obtaining grading for IPO shall disclose all the grading obtained, along with the rationale discretion furnished by the credit rating agency for each of the grade obtained in the prospectus, abridged prospectus, issue advertisement and at all other place where the issuer company is advertising the IPO. Grading of the IPO is and essential tool for the investor for availing information and act as guidance tool.
Can an Equity share be offered at discount?
According to the Company Act, 53 any share issued by the company at a discount shall be void. If the company contravene the provision the company shall be punishable with a fine which shall not be less than one lakh rupees and which may extend to five lakh rupees. But the proviso to section 53 does allow the company to issue Sweat share at a discount to its employee.
Can a company issue share after IPO for capital?
The company acquires its capital only from the primary market. The trading on the secondary market does not provide or contribute any capital inflow to the company. Thus, in order for the company for future expansion, the right issue can be made by the company for its capital requirement. The right issue can be for the same class of share that has already been issued.
Can a company buy back its own shares?
The main factor behind the buyback of the share is for the consolidation of the share and to improve the key financial ratios. According to section 68(1) of the Company Act 2013, a company may purchase its own share or the other specified securities from its following fund;
- Its free reserve
- The securities premium accounts
- Proceeds from any share and other specified securities.
However, a buyback cannot be done from the proceed of an earlier issue of the same kind of share of specified securities. Thus, the company must have sufficient balance in any one of these account for the purpose of buyback. The company must also have the power to buy back which must be authorised by the article of association. The buyback can be made by the approval of the board of the director at a board meeting and/or by a special resolution must be passed by the shareholder at the general meeting, depending upon the quantum of buyback.
Accordingly, the board of director can authorise buyback up to 10% of the paid up capital and free reserve and shareholder can authorise a buyback of 25% of the paid up capital and free reserve by a special resolution in a financial year.
What is the factor that influence equity financing, investor decision and investor protection policy?
The factor effecting the preference for choosing any instrument from the investor point of view are;
- Tax on The Return Received,
- Financial Ratio,
- Marketable and Liquidity.
There are number of ways through which an investment can be channelized but is still depend upon certain key financial ration upon which the company’s performance is measured. Some of which are earning per share (EPS), Return on capital employed, debt to equity ratio, and debt coverage ratios and PE ratios. Ultimately the aim of every investor is to maximise his return on the capital invested, but the investment can be made prudently by analysing the performance and minimising the risk by making a sound decision.
In order to protect the interest of the investor SEBI has initiated various investor protection scheme accordingly under the Securities And Exchange Board of India (Investor Protection and Education Fund) Regulations, 2009 the objective of such Fund shall be to utilised for the purpose of protection of investors and promotion of investor education and awareness in accordance with these regulations laid down.
Equity and debt investment are the most preferred means of raising capital. But there is always a trade-off to made by the company whether they preferred a highly geared business with huge fix cost or a low geared business with more diluted equity. One of the ways to address the problem is to go with non-convertible redeemable debenture to raise fund from the market as the rate of return is high, non- participation in the business, the lower post-tax cost of capital and it is redeemable with 3 to 5 years. Since the equity is also a risk capital the return on investment is much higher than other investment.
Ultimately, it’s the risk appetite of the investor, the nature of the company, and the macroeconomic factor that decides the financing investment in equity.
- Section 53 of the company Act 2013
- Section 62 of the Company Act 2013