- Shares represent an ownership interest in a company and are a popular source of finance for many businesses.
- Companies issue shares to raise capital from investors in exchange for ownership in the company. In this way, shares represent an important source of long-term financing for companies.
Features of Shares as a Source of Finance:
- Ownership Interest: Shares represent a partial ownership interest in a company, which means shareholders have certain rights and privileges, including the right to vote on company decisions and receive a share of the company’s profits.
- Dividend Payments: Companies may choose to pay out a portion of their profits to shareholders in the form of dividends, which can provide a steady income stream for investors.
- Capital Raising: Companies can issue new shares to raise capital, which can be used to fund expansion, research and development, or other business activities.
- Trading on Stock Exchange: Shares can be bought and sold on a stock exchange, which means investors can easily sell their shares if they need to raise cash quickly.
- Limited Liability: Shareholders are not personally liable for the company’s debts, which means they can only lose the amount of money they invested in the company.
Types of shares
- Ordinary Shares: Also known as common shares, these are the most basic type of shares that a company can issue. Ordinary shareholders have the right to vote at company meetings and receive dividends if the company is profitable. They also bear the highest level of risk, as they are the last in line to be paid if the company goes bankrupt.
- Preference Shares: These shares offer a fixed dividend to shareholders, which is paid out before any dividends are paid to ordinary shareholders. Preference shareholders do not have voting rights, but they are typically less risky than ordinary shares.
- Cumulative Preference Shares: Similar to preference shares, cumulative preference shares also offer a fixed dividend to shareholders. However, if the company is unable to pay the dividend in a given year, the amount owed accumulates and must be paid before any dividends are paid to ordinary shareholders.
- Redeemable Shares: These shares can be bought back by the company at a predetermined price, either at a specified date or at the company’s discretion. They are often used to raise capital for a specific purpose.
- Non-voting Shares: These shares do not carry any voting rights, but they may still be entitled to dividends. They are often issued to employees or investors who do not want to be involved in the decision-making process of the company.
Rights Issue vs Bonus Issue
- For an existing company, there are two main ways in which shares can be issued to shareholders:
- Rights Issue:
- A way for a company to raise additional capital
- Existing shareholders offered new shares at a discounted price
- Shareholders have the right, but not obligation, to buy the new shares
- Proceeds from the sale of new shares used to fund company growth plans or pay down debt
- A rights issue results in additional capital being raised
- Bonus Issue:
- A way for a company to reward its existing shareholders
- Additional shares issued to existing shareholders for free
- Number of shares outstanding increases, making the stock potentially more attractive to investors
- Improves the liquidity of the stock
- No capital is raised when a bonus issue is conducted
Ideal Uses of Shares as a Source of Finance:
- Long-term Financing: Shares are an ideal source of long-term financing for companies, as they provide a stable source of funding that can be used to fund growth and expansion over time.
- High-risk Ventures: Companies engaged in high-risk ventures, such as biotechnology or renewable energy, may find it difficult to secure traditional debt financing, and may therefore turn to shares to raise capital.
- Start-ups: Start-up companies may find it difficult to secure debt financing or other forms of financing due to their lack of track record, and may therefore turn to shares to raise capital.
Benefits of Shares as a Source of Finance:
- Access to Capital: By issuing shares, companies can access a large pool of capital from a diverse group of investors.
- No Interest Payments: Unlike debt financing, shares do not require interest payments, which can be a significant cost savings for companies.
- Improved Image: Issuing shares can improve a company’s image and reputation, as it signals to investors and stakeholders that the company is financially stable and has a long-term vision.
- No Repayment Obligations: Companies are not obligated to repay shareholders, which can provide more financial flexibility for the company.
- Attractive to Investors: Shares can be an attractive investment for investors, as they offer the potential for both capital gains and dividend income.
Drawbacks of Shares as a Source of Finance:
- Dilution of Ownership: By issuing new shares, companies dilute the ownership of existing shareholders, which can lead to a loss of control over the company.
- Costly: Issuing shares can be a costly and time-consuming process, as companies must comply with various legal and regulatory requirements.
- Shareholder Pressure: Shareholders may exert pressure on the company to meet short-term goals or increase dividend payments, which can be at odds with the company’s long-term strategy.
- Disclosure Requirements: Companies that issue shares are required to disclose certain financial and operational information, which can limit their ability to keep certain information confidential.
- Risk of Undervaluation: Shares may be undervalued if investors do not perceive the company’s prospects to be as strong as the company does, which can lead to a lower share price and less capital raised.