The main source of finance for a company is the equity investment it receives from its shareholders. The shareholders receive shares of the company in exchange for the shares of the company. The price of the share is usually the price that market participants are willing to pay for it.
Therefore, the price usually depends on the stock market. A company only receives compensation for its shares when it issues the shares initially. Any subsequent transactions related to those shares do not affect the accounts or finance of the company.
When a company issues its shares, it will receive compensation from the shareholders who buy the share. Every share has a par value, which is the predetermined value of that share. However, due to several factors, the actual price that shareholders pay for it might be different from its par value.
For example, the par value of a share may be $100, but shareholders may be willing to pay $150 for it. For the company, while $150 is capital, it must split it into two portions.
When a company receives compensation for shares above their par value, the excess amount is known as additional paid-in capital. In the example above, the par value of the share is $100, and the actual price the company receives is $150.
Therefore, $50 ($150 – $100) is the additional paid-in capital. It is also known as share premium. The additional paid-in capital is an account that only increases due to the issuance of new shares above their par value. However, there are some ways in which companies can also reduce it.
Reducing Additional Paid-in Capital:
A reduction in the additional paid-in capital account is very rare. It is because it is a reserve account. Therefore, a company cannot use the account unless needed in specific conditions.
Usually, any reduction in the paid-in capital account will first affect the additional paid-in capital account. The conditions that result in a reduction in the additional paid-in capital balance of a company are the following.
1) Stock Buybacks
A stock buyback is a process used by a company to buy back shares from the market. It is also a way for companies to return wealth to their shareholders without paying them dividends or through stock appreciation. In a stock buyback, a company pays its shareholders cash in exchange for their shares.
On the other hand, the company also decreases its reserves for the value of the shares it repurchased. Stock buybacks work in many different ways. For example, a company can use tender offers to buy back shares or buy its shares from the stock market directly.
As mentioned above, the additional paid-in capital balance will reduce due to stock buybacks. However, if the value of the shares rebought is above the balance in the additional paid-in capital balance, then the company can also utilize its paid-in capital balance.
However, the company won’t usually buy enough shares to affect its paid-in capital account as well.
2) Liquidating Dividends
During a partial or full liquidation, companies must make payments to their shareholders. Sometimes, companies may also not have enough cash to cover the issue of a dividend-paying stock. In both these cases, the company must pay its shareholders from its reserves. These are known as liquidating dividends.
In both scenarios, the company must liquidate its funds in its reserves to pay its shareholders. Usually, liquidating dividends are rare in companies but can still decrease the additional paid-in and the paid-in capital balances of a company.
Like stock buybacks, liquidating dividends also affect the paid-in capital balance. However, a company must first adjust it against any balance in the additional paid-in capital balance and then take the remainder to the paid-in capital account.
For example, if a company has a total cash dividend of $20,000 but only has cash reserves of $15,000, it will cover the remaining $5,000 from the additional paid-in capital balance.
3) Vertical Merger
In business terms, a merger is when two companies combine to group their resources to increase their market shares. A vertical merger is a merger between two participants of the same supply chain. In other words, a vertical merger is when a supplier and customer merge.
There are many advantages of disadvantages of vertical mergers for companies. Companies can reduce their additional paid-in and paid-in capital balances to nil through a vertical merger.
A vertical merger is a great way for a company to reduce its additional paid-in capital balance significantly. It can also use it to reduce its paid-in capital balance. However, for that to happen, the subsidiary must be created, funded and owned by only the parent company.
Conclusion
Companies issue shares to receive finance. The shares have a par value, which is their original value. However, shareholders may pay higher than par value for the share.
A company issuing shares for a price over its par value must take the excess amount to the additional paid-in capital account, also known as share premium account.
There are different ways to reduce the additional paid-in capital of a business, including stock buybacks, liquidating dividends and vertical mergers.