Equity Shares are referred to as one of the most important sources of finance from the perspective of the company.
Companies mostly issue equity shares as a means of long-term external financing that helps them to meet their respective aims and objectives, either pertaining to expansion or some other need.
Furthermore, it is also important to realize the fact that equity shares can only be issued to the general public by companies that are already listed on the stock exchange, and therefore, this option might not be readily available to other companies in this regard.
What are Equity Shares?
Equity Shares mainly involve companies giving a certain part of ownership in the company to the investors, against a monetary down payment.
In most cases, equity shares are considered to be perpetuity, but they can also be issued for a shorter period of time if there’s an option to do so.
Normally, equity shares are traded on the stock exchange, which is considered a market where purchasing and selling of shares take place.
Therefore, it is important to consider the fact that only companies that have a considerable size of operations are allowed to publicly sell their shares to the general public.
Which companies are allowed to issue equity shares?
In order to be eligible to sell equity shares to the general public, companies need to make sure that they are listed on the stock exchange.
Listing on the stock exchange is considered to be a relatively harder process because there are a lot of obligations that need to be duly met by the companies.
For example, they need to hire an underwriter, get an IPO, and then have an authorized equity share capital before they can formally start selling their shares to the general public.
Normally only those companies are allowed to sell shares to the general public with a relatively expansive state of operations.
They might also need to have certain operations in place, and hence, they must have properly audited financials to show the basis on which investors can choose whether they want to invest or not.
Who can purchase Equity Shares?
Once the company is formally listed on the stock exchange, it can sell its shares to the general public.
In order for the general public to be able to purchase these shares, it is important for them to realize the fact that they need to get registered with the local stock exchange and be declared as a member.
Otherwise, they can get in touch with stockbrokers in order to begin trading (i.e. purchase and selling) shares on the stock exchange.
Types of Equity Shares
There are several different types of equity shares that can be issued by the organization, primarily depending on the main purpose of the equity shares and what companies are actually seeking when it comes to equity shares.
Hence, the following are the most common types of common shares.
- Common Equity Shares: Common Shareholders tend to constitute the most important type of voters from the company’s perspective. In this regard, it is important to realize that they are also referred to as the main risk-bearers of the company. This is because they are not entitled to a yearly fixed rate of return (like other types of shareholders or debt holders). Similarly, common equity shareholders are also considered the last to be paid upon liquidation. This implies that they are only paid after the organization has settled all obligations. To compensate them for the higher risk element, they are also given the right to vote in the company, for the Board of Directors, and the Chairman. Therefore, these types of equity shareholders have a right to how the company functions.
- Preference Equity Shares: Preference Equity Shares are also considered a category of equity shares within a company. It can be seen that preference shareholders do not have any voting rights. They are entitled to their shareholder’s dividends due to their investment within the company. Hence, preference shareholders are mostly non-participating, and hence they do not get involved with the functionality of the company. In the same manner, it can also be seen that preference shares are supposed to be paid their dividend every year, regardless of the volume of profit that the company generates. In the event that the organization chooses not to pay dividends for a particular year, the dividend will be carried forward to the next year.
An exception to these classes of shares, it is also important to realize the fact that there are several types of equity that exist within an organization, like sweat equity.
However, preference share equity and common share equity tend to be the main types of equity and exist on the financial statements of almost all listed companies.
Advantages of Equity Shares
From the organization’s perspective, it can be seen that there are multiple different advantages to issuing equity shares.
These advantages are manifold and are mentioned below:
- No Need to Repay the Amount Generated in Equity Shares: The greatest advantage of equity shares is that the amount raised by selling shares to the general public does not need to be paid back by the organization. Unlike other debt instruments, like a long-term loan, equity shares do not need to be settled in terms of principal.
- Cost-Effective Source of Finance: Once the company is listed on the stock exchange, equity shares can be easily issued to the general public at a minimal cost. It does not involve significant costs because the company has already been listed on the stock exchange. If the company does not have authorized share capital, it can be increased at a cheaper cost too.
- No Need for Collaterals: Since equity shares are sold to the general public, it can be seen that they do not need to be backed with collaterals. This is an advantage from the company’s perspective because it does not require any assets to be put up as collaterals.
- Rate of Return on Equity Shares is Variable: For almost all equity shares (other than preference shares), the dividend rate is directly contingent on the volume of profit generated by the organization. This implies that organizations can choose their dividend rates based on the volume of profit they are generating. If they want to retain profits for a particular year because of an expansionary project, they might choose to do so. For other long-term instruments, like debt, a fixed rate of return has to be paid regardless of the profit the organization generates.
- No Adverse Impact on Leveraging: Gearing and leveraging ratios are important from the organization’s perspective. Taking on debt increases the company’s gearing ratio, which considerably pushes up its risk profile. Hence, with high gearing in the company, they might face a higher credit risk.