There are various ways to raise capital for a company. The company can use debt capital to fund a business (such as a bank loan) or it can raise equity capital by the sale of shares in the business. This can be more appealing and/or appropriate than other methods, but it raises further issues on the business that must be considered.
Advantages of Share Capital
One of the attractions of raising capital via the sale of shares is that the company does not have repayment requirements for the initial investment or for interest payments. This can make it more appealing than other forms, such as bank loans and bonds, that are debts of the company. Debts require the company to make payments at regular intervals in relation to interest, as well as eventually repaying the initial amount that was borrowed. Any shares sold can require a distribution of profits as a dividend but these can be halted if necessary. Therefore, the business is given more flexibility over its finances.
Any money raised through the sale of shares can be used by the company however it wants. There are no stipulations or requirements attached to the funds. In comparison a creditor can limit the use of the funds they will lend to the company, which will restrict how the company can use them.
Raising equity via share sales is also very flexible. The business has full control over how many shares to issue, what to initially charge for them and when it wishes to issue them. It can also issue further shares in the future if it wishes to raise more money. The company can also decide on the type of shares it issues and what rights these give the shareholders, and it can also repurchase issued shares if desired.
Another advantage is that there is a much lower risk that the business will become bankrupt. Shareholders cannot force a company into bankruptcy if it fails to make payments (unlike creditors if the company fails to repay interest).
Shareholders want the business to succeed and can bring in skills and experience and assist with business decisions.
Disadvantages of Share Capital
When a business sells shares to raise equity it is effectively reducing its control and ownership over the company. Every share is a tiny piece of ownership in that company and so has benefits for the shareholder. Shareholders have rights in relation to voting on business deals and corporate policy and even the management of the company. Where the shareholders hold a majority of the company, they can remove the current leadership and bring in new management where they disapprove of how things are operating. Issuing shares can also result in a hostile takeover since a competitor could acquire the majority of the voting shares.
Because of the fact that shareholders take more risks than creditors in the event of the company going bankrupt, shareholders expect a higher rate of return on their investment than creditors. Therefore, a company typically loses more stock for a lower price to a shareholder to compensate for this risk.
An additional cost is that a company cannot deduct any dividends it pays out or any money it uses to repurchase shares. In comparison, any interest paid on a debt can be deducted from its taxes.
There is also a cost implication for the arrangement of organising a public share offering since the company has to prepare an IPO (initial public offering) prospectus to invite the general public to buy shares. There will probably also be advertising costs and the company may need an underwriting agreement with an underwriter to purchase shares that are not purchased by investors. The fee for this will have to be paid whether or not the shares are all purchased by investors. The company will probably also need to take legal advice, which is another cost.
There is also a time implication. Shareholders will need to be kept updated by the company on how it is performing and other relevant matters. In the initial states of offering shares for sale, the focus of the business can be moved from the main business activities to dealing with the issues around the share sales. The company will need to prepare the prospectus and other related documents as well as organising advertising of the sale of shares and arranging for the implementation of the shares being issued.
Although it is possible to issue further shares in the future, this does have an impact on the value of the shares that have already been sold. Usually this will mean that the share price will drop and so will the dividends paid out on each share. This can anger current shareholders who then use their voting power as described above.
Finally, any company issuing shares to the public has to make sure that it discloses certain information on the finances of the company and how it functions. This obviously will result in a cost to the firm but also means that information that was previously able to remain private is now in the public domain.
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This article is intended to be no more than a general guide and does not comprise legal advice. You are strongly advised to take legal advice if you are involved in a commercial transaction.