A company’s capital is divided into units known as shares. To raise funds, companies can issue the following types of shares: equity shares and preference shares.
Equity Shares (or Ordinary Shares)
Any share that is not a preference share is an equity share. This means that if the shareholder is not entitled to a fixed dividend in preference to others, or if there is no prior right for the capital to be repaid, the share capital will be treated as equity share capital.
In other words, equity shares participate in the profits of a company after all preferential rights have been satisfied. Equity shareholders are the effective owners of the company. They receive dividends after the payment of all expenses and dividends to preference shareholders.
Preference shares are those shares that are prioritized in the payment of dividends at a fixed rate, and sometimes also in the return of capital in the event of the company’s closure.
Preference shares can be divided into the following classes:
Holders of these shares are entitled to all arrears. For example, suppose that a company issues preference shares valued at $10 per share, carrying dividends at the rate of 10%.
Further, suppose that a dividend was not paid for 2017 and 2018. In 2019, the firm’s profitability is good, and so the dividend for both 2017 and 2018 will be payable in 2019.
For non-cumulative preference shares, arrears are not payable. In the above example, in 2019, only the dividend for 2019 will be paid (i.e., not the accumulated dividends for 2017 or 2018).
When preference shares are redeemable out of the profits through the creation of a capital redemption reserve fund, through the issue of shares, or through the sale proceeds of the property of the company, they are called redeemable preference shares.
When preference shares participate like equity shares in the profit of a company, in addition to their fixed profit, they are known as participating preference shares.
Guaranteed preference shares are shares for which a fixed dividend is guaranteed by the vendors or some other party. If the profit in a particular year is insufficient to pay the dividend, guarantors pay the amount.
The company itself cannot give a guarantee. The guarantee must be given by the vendor or promoter.
Evaluation of Raising Funds by Issuing Shares
Shareholders are effectively the owners of the company. They bear the firm’s ultimate risk. These shareholders are the last to claim their dividend in the earning and resources of the enterprise.
It is always in the interest of a company to procure its initial capital through the issue of shares.
Advantages of Raising Funds by Issuing Shares
The following are some of the main advantages associated with raising funds by issuing shares:
(i) Absence of fixed liability: The company does not guarantee the dividend rate on equity shares, and so there is no fixed liability as in the case of debentures. For cumulative preference shares, dividends are not paid out of losses.
(ii) No charge on assets: Shares are issued without any security or charge on assets. In this way, the company procures funds without any charge on its assets or even pleading any security.
(iii) Preferred by adventurous investors: The dividend rate is not guaranteed on equity shares. Dividends may be paid at a very high rate when profit is large. Therefore, it is preferred by adventurous investors.
(iv) Preferred by companies in an unsound financial position: When a company is financially unsound, equity shareholders bear the risk without asking for dividends.
(v) No repayment of liability: Funds raised by issuing shares need not be refunded. The shareholders cannot claim a refund, and so the company does not have any liability to repay share capital.
(vi) Promotes financial health: Companies are not forced to pay dividends. In fact, the dividend rate on equity shares is not even specified. As such, the company can maintain a sufficient reserve and build itself into a financially sound position.
(vii) Supply of long-term fixed capital: The company receives long-term fixed capital.
Disadvantages of Raising Funds by Issuing Shares
The procurement of funds by issuing shares results in the following disadvantages:
(i) Danger of overcapitalization: The funds are easily available, there is no charge on assets, and there is no guarantee regarding the dividend rate. As such, firms may suffer from overcapitalization after raising funds by issuing shares.
(ii) No investment by cautious investors: Cautious investors prefer not to invest in equity shares because the return on these shares is not regular or guaranteed.
(iii) Danger of manipulation: The management of the company can declare dividends at higher or lower rates, which will cause the value of shares to fluctuate. In this context, there is always the danger of manipulation.
(iv) Disadvantageous for companies in a sound financial position: Companies in a sound financial position will have to pay dividends at higher rates, even when loans at lower rates are available in the market.
(v) Dividend uncertainty: The rate of dividend is not assumed and not even regular. Investors, therefore, are uncertain about their potential earnings.