Characteristics of Equity Shares

What this chapter covers

Chapter 2 carries 6 marks out of 100 — 6% of the paper.

LEARNING OBJECTIVES: After studying this chapter, you should know about: Investors in equity shares · Rights of a Shareholder · Risks in Equity Investing · Equity related terminology · Corporate Actions · Preference Shares, Rights Issue and Preferential Issue

2.1 Investors in equity shares

A company raises equity capital to meet its need for long-term funds for expansion or continuing operations of the company. Equity capital does not impose any liability on the company in terms of returns or repayment. However, when a company issues equity capital, the investors also get proportionate control and ownership.

That is the trade the company makes — no repayment obligation, but a share of control given away.

A company can raise capital from different categories of investors. Different categories of investors have different requirements in terms of returns, risk and management control.

a. Promoters

Promoters are the group of investors who set up the company and bring in the initial capital required to start the business. This is the risk capital. At the initial stage the entire control of the company is with the promoters. They may bring in additional capital as and when required.

As the capital needs of the business grow, promoters may invite other investors. These may include both institutions and retail public investors.

Why they hold on: promoters usually retain the majority shareholding in the company so that they can continue to control its affairs even after their stakes are diluted.

And why they are entitled to run it: the stage at which the promoters bring in the initial capital is the riskiest. Further, it is generally assumed that the promoter knows the business the best. Thus, the promoter / owner is the logical manager of the business. However, ownership and management may be in separate hands.

Note that last sentence — the assumption is a general one, not a rule.

b. Institutional Investors

Institutional investors include financial institutions, venture capital companies, mutual funds, foreign financial institutions and banks among others. These are professional investors who have the ability to evaluate the business proposition, the risks associated with it and the expected returns.

How they come in: the company may allot shares to such investors through a private placement or preferential issue of shares. The risks and returns depend upon the stage at which the institutional investors bring in capital.

They differ among themselves in two ways — stage and activism.

Some like venture capital firms may be willing to bring in capital for companies in the start-up stage while others like financial institutions invest in more established firms. Institutional investors such as venture capital firms may be actively involved in the management of the company while others like mutual funds may be more passive investors.

And SEBI has addressed that balance: to strike a balance between being a passive and active investor, SEBI has issued guidelines for mutual funds and alternative investment funds to ensure better corporate governance in listed companies where the funds have invested — the Stewardship Code for all Mutual Funds and all categories of AIFs, in relation to their investment in listed equities dated December 24, 2019.

Exit matters to them: apart from the attractiveness of the business proposition, institutional investors would also be interested in factors such as exit options, since many of them may hold a significant proportion of the equity capital. Many institutional investors like venture capitalists, encourage a company to offer its shares to the public investors as an exit option for themselves.

That is one reason IPOs happen at all — an early institutional investor needs a way out.

c. Public Investors

When the equity shares are held by promoters and a few investors, it is said to be a closely held company. Such companies may also be private companies, which are not required to disclose too much of information about themselves to the public or the regulators.

When a company offers its equity shares to the public at large and lists its shares on a stock exchange, it moves from being a privately held or closely held company, to a publicly held company, which agrees to disclose periodic information about its operations and business to the public.

Listing buys capital and costs disclosure.

Investors, other than promoters, participate in the equity of a company when a company comes out with a public issue of shares (IPO). A public issue of shares requires regulatory compliance with SEBI's guidelines and regulations governing listing of the shares on a stock exchange.

The categories of public investor: public investors in shares may be retail investors, high networth individuals (HNI), non-institutional investors or institutional investors.

And what each wants: retail investors, and to a great extent HNIs, are more interested in the returns that they can generate from their investment from capital appreciation in the value of the shares and dividend, rather than in the control and management of the company.

Large stake holders and institutional shareholders actively participate in the affairs of the company. Some large institutional investors may be given a seat on the board of the company. Regulations require extensive and timely disclosures of all information that affects the interests of the public investors in a company.

2.2 Rights of a shareholder

Equity share capital has distinct features which define its risk and return... The equity shareholders have specific rights and privileges in the company as compared to debt holders.

Ownership Rights

Issuing ordinary equity capital implies that the company is giving ownership rights to the shareholders. Investors are given voting rights which allow them to vote on important decisions taken by the company. The voting rights are in proportion to the number of shares held by the investor and allow them to express their views by voting 'For' or 'Against' a proposal.

Where those votes are cast: the General Body Meeting of shareholders is the highest decision making authority in a corporate setup. Typically, a company will call a meeting of the shareholders once a year. This meeting is known as the Annual General Meeting (AGM). Shareholders have a right to attend the AGM of the company and participate in the proceedings. Shareholders have a right to express opinions on various aspects of the company working and vote on the various proposals put forth in the AGM.

The General Body Meeting is the highest authority — above the board.

Right to Dividend

Ownership rights in a company also mean that the investors who hold equity shares are entitled to participate in the profits of the company. This participation will be in the form of dividends that are periodically declared by the company.

Ownership Transfer Rights

A company is not required to return the equity capital to the investor as it is perpetual in nature. However, investors can sell their shares to other investors who may want to buy the shares.

The right to transfer is what makes perpetual capital tolerable to an investor.

Other Rights

Shareholders have other rights such as right to inspect documents related to company workings, right to legal recourse in case of mis-management or wrong disclosure.

And a special right sometimes granted: shareholders are sometimes provided with certain special rights such as Anti-dilution rights. Anti-dilution provision gives an investor the right to maintain the same percentage ownership in a company by purchasing a proportional amount of shares in future when securities are issued.

2.3 Risks in equity investing

No Fixed Return

The return in the form of dividend from equity is not pre-defined either in terms of the percentage of dividend or the date on which the payment will be made. Dividend is paid if the company makes sufficient profits and the management of the company feels it is appropriate for some of the profits to be distributed among the shareholders.

Two conditions, not one — sufficient profits and a management decision to distribute.

In case the company makes losses or the profits made by the company is ploughed back for the expansion and other operations of the company, the shareholders may not get a dividend.

The other source of return for the holder of equity shares is the appreciation in the price of the share in the secondary market. This constitutes the major portion of the return for the equity investor.

Note that — capital appreciation, not dividend, is the major portion of the return.

But it cuts both ways: if the company's performance is bad or if the stock markets are going through a downturn, the value of the shares may actually depreciate leading to a loss for the investor. There is no guarantee that the principal amount invested in equity shares will remain intact.

No Fixed Tenor

Equity shares are issued for perpetuity. This means that there is no period of maturity after which the money will be returned to the shareholders. Investors who want to exit their investments may do so by selling the shares on the stock exchange to other investors.

Liquidity Risk

A shareholder has the right to sell his shares to other investors. However, there may be a difference between the price expected by the seller and the price offered by the potential buyer. This is referred to as "bid ask spread" or liquidity risk.

The risk to the shareholder arises if the shares are illiquid and not easily sold at its market value or if the shares are unlisted. The investor's investment may get stuck without an exit option or they may sell their shares at lower than fair value resulting in loss.

Two harms — no exit, or exit at a bad price.

No Collateral Security

Equity capital is not secured by the assets of the company. The cash and assets of the company are first applied to settle the claims of the lenders and creditors. The claims of the equity shareholders always rank last in order of preference.

In both good times and bad: during the normal course of operations of the company, dividends are payable to the equity shareholders only after the expenses, interest and taxes are provided for. In the event of liquidation of the company, the equity shareholders are only entitled to a refund of capital after the claims of all the other creditors are satisfied from the sale of the company's assets.

2.4 Equity terminology

i. Face Value

The total equity capital required by a company is divided into smaller denomination called the face value or par value of the equity shares. Face value of a share represents the book value of the share and always remains fixed. Face value of a share helps in calculating the dividend pay-out to the investors when dividends are declared by the company.

Two uses — it denominates the capital, and it is the base for dividend.

Example 1: If a company wishes to raise Rs. 10,00,000 (ten lakh), this can be denominated as: one lakh shares with a face value of Rs. 10; or two lakh shares with a face value of Rs. 5; or ten lakh shares with a face value of Re. 1.

ii. Share Premium

Companies issue shares at face value or at prices higher than the face value depending on the future prospects of the company. The excess amount received by the company over the face value is called the share premium.

Example 2: A company issues 1 lakh equity shares of face value of Rs. 10 each, to the public at Rs. 50 per share, i.e. Face Value of each share is Rs. 10 (par value) and Share Premium on each share is Rs. 40 (Rs. 50 – Rs. 10).

iii. Authorised Capital

The maximum amount of equity capital that a company will have is defined in the Memorandum of Association (MoA) of the company and is called its authorised capital.

Note where it lives — the Memorandum of Association.

iv. Issued Capital

The company may issue a portion of its authorised capital as and when it requires capital. The capital may be issued to the promoters, public or to specified investors. The portion of authorised capital that has been issued to investors is called issued capital.

The capital may be issued by the company either at its face value or at a premium (higher than the face value). In special cases shares may be issued at a discount (lower than the face value).

v. Paid-up Capital

When investors subscribe to the capital issued by a company, they may be required to pay the entire price at the time of issue or in tranches (instalments). The portion of the issued capital that has been fully paid-up by the shareholders is the paid-up capital of the company.

vi. Outstanding shares

Outstanding shares refer to the total number of shares issued by the company to its investors (including retail and institutions).

The worked example

Example 3: A company decides that the maximum equity capital it needs is Rs.20 crore. In the initial stages, the need is Rs.10 crore. It issues equity shares of Rs.10 face value, at par. Investors are required to pay Rs.5 per share with application and Rs.5 after 6 months.

Number of Outstanding Shares: 1 crore (i.e. Rs. 10 crore/ Rs. 10)

And the rule the example illustrates:

Paid up capital is always less than or equal to issued capital; Issued capital is always less than or equal to authorised capital. Authorised capital is the maximum amount that can be issued or paid up.

Authorised ≥ issued ≥ paid-up. That ordering is one of the most examinable points in the chapter.

vii and viii. Fully and partly paid-up shares

Fully paid shares are those, of which entire face value amount is collected from shareholders upfront. Shareholder is not liable for any amount.

Partly paid-up shares are those on which entire face value amount is not collected from shareholders upfront. That means, company can make call for balance unpaid portion and the shareholder will be liable to pay such call money. If the shareholder does not pay the call money as per schedule, the shares can be forfeited, including the amount already paid thereon, by company.

Forfeiture takes the shares and the money already paid on them.

2.5 Corporate actions

A corporate action is an event initiated by a public company that will bring an actual change to the securities—equity or debt—issued by the company. Corporate actions are typically agreed upon by a company's board of directors and authorized by the shareholders.

Board agrees, shareholders authorise.

a. Dividend

The most common corporate action is payment of dividend. Equity shareholders are entitled to share in the profits of the company. One way to do this is through the dividend that the company may periodically declare.

Dividend declared by a company is not pre-fixed in terms of the percentage of the dividend or the period when it will be declared. Dividends are declared by the company when there is sufficient profit that can be distributed among the shareholders. The board of directors of the company will take a decision on the dividend to be declared. Shareholders approve such dividend in an annual general meeting.

How it is computed: dividend is computed as a percentage of the face value of the shares. A 40 percent dividend declared by a company will translate into a dividend of Rs. 4 for a share with a face or par value of Rs. 10 (i.e. 1040/100), Rs. 2 for a share with a face value of Rs. 5 (i.e. 540/100).

Face value, never market price — the single most common error on this topic.

And SEBI has removed the ambiguity: to ensure clarity for investors, SEBI has mandated that listed companies declare the dividend in terms of rupee per share.

Timing: dividend for a company is usually declared at the end of a year which is called the final dividend. However, companies may also declare dividends during the year, called the interim dividend. Many companies have now made a regular practice of quarterly dividends.

Dividend yield brings market price back in: the dividend declared by a company is a percentage of the face value of its shares. When the dividend received by an investor is compared to the market price of the share, it is called the dividend yield of the share.

Example 4: A company declares a dividend of 60 percent on its shares which have a face value of Rs. 2. The market price of the share is Rs. 80. In this case, the dividend amount is Rs. 1.20 per share. The dividend yield is 1.5 percent (i.e. 1.2/80*100)

Two different denominators: the dividend uses face value, the yield uses market price.

b. Buyback of shares

Buy-back of shares refers to repurchase of shares by the company from its existing shareholders. During the buy-back, the company usually offers a higher price to the shareholders. However, participation in a share buyback is voluntary. The shares acquired by a company in buyback are extinguished and this results in reduction of share capital. Buyback of securities are governed by SEBI (Buy-Back of Securities) Regulations, 2018.

Voluntary for the shareholder; extinguishing for the shares.

c. Bonus issue

A company may issue additional shares to existing shareholders without any capital contribution from the shareholders based on the number of shares an investor holds. This is known as a bonus issue. The bonus is issued against accumulated profit of the company. Bonus issue results in increase in number of outstanding shares of the company.

Example 5: ABC Company Ltd. declares a bonus issue in the ratio 1:2. This means that ABC Company Ltd. will issue 1 bonus share for every 2 shares held by the shareholder.

No money comes in from shareholders — the shares are issued against accumulated profit of the company.

d. Stock split and Consolidation

A company may decide to change the face value of its shares. This is done through stock split or consolidation methods. These methods change the number of outstanding shares. However, in both the cases, the value of the shares held by a shareholder remains unchanged.

When a higher face value of a share is reduced to a lower face value, it is called a stock split. It increases the number of shares in the hands of an investor, but reduces the face value of each share.

Example 6: Mr. P holds 100 shares of face value Rs. 10 of ABC Ltd. The company decides to divide each share into 2 shares with face value of Rs. 5 each. Before Stock Split: Value of Mr. P's holdings is Rs. 1000 (i.e. Rs. 10 x 100). After Stock Split: Mr. P will now hold 200 shares of face value Rs. 5. Therefore, value of Mr. P's holdings is Rs. 1000 (i.e. Rs. 5 x 200).

A consolidation refers to increasing the face value of a share from lower amount to higher amount. This reduces the number of shares held by an investor, but increases the face value of each share.

Example 7: Mr. S holds 100 shares of face value Rs. 2 of XYZ Ltd. The company decides to club 5 shares into 1 share with face value of Rs. 10 each. Before Stock Consolidation: Value of Mr. S's holdings is Rs. 200 (i.e. Rs. 2 x 100). After Stock Consolidation: Mr. S will now hold 20 shares of face value Rs. 10. Therefore, value of Mr. S's holdings is Rs. 200 (i.e. Rs. 10 x 20).

In both, the total value is unchanged. Only the number of shares and the face value move, in opposite directions.

2.6 Reduction of share capital

The company may reduce its share capital in the following ways:

Extinguishment of shares through buyback of shares.

Forfeiture of shares in case of partly paid shares, where the balance call money remains unpaid after sufficient reminders for making the balance payment.

Two routes — buyback and forfeiture.

This proposed reduction in the capital must be approved by special resolution passed by the company. If the capital of a company is reduced, it results in alteration of its memorandum by reducing the amount of its share capital and outstanding shares accordingly.

A special resolution, and an alteration of the memorandum — because that is where authorised capital is defined.

One bar: in case the company is in arrears in the repayment of any deposits accepted by it or the interest payable, then reduction of capital cannot be made.

2.7 Preference shares

When we talk of shares of a company we usually refer to the ordinary shares of a company. A company may also raise equity capital with varying rights and entitlements. These are called preference shares because they may offer certain special features or benefits to the investor.

What is given up: some benefits that investors in ordinary equity capital have, such as, voting rights, may instead not be available to preference shareholders.

What is gained: preference shares are usually given preference over equity shares in the payment of dividends and the repayment of capital, if the company is wound up.

Preference over equity shares — a point the sample question tests, since preference shares do not rank ahead of debenture holders.

The dividend: dividend is paid to the preference shareholder at a fixed rate mentioned at the time of the issue of the shares.

Two variants:

Participating preference shares — the terms of issue may allow the preference shareholders to participate in the residual profits too in some defined ratio.

Cumulative preference shares — preference shareholders are paid dividend only if the company has sufficient profits. The unpaid dividend may be carried forward to the following year(s) and paid if there are profits to pay the dividends, if the terms of issue of the shares so allow.

Return and listing: the returns for the preference shares are primarily from the dividend the company pays. Non-convertible preference shares issued through a public issue or private placement may be listed on a stock exchange, provided the issue meets the terms laid down by SEBI in its regulations.

And why the price barely moves: the scope for capital appreciation in these types of shares may be limited because they do not participate in the profits of the company. Their value is not affected by the over-performance or under-performance of the company.

Preference shares compared with debentures

Though preference shares are similar to debentures, they differ on the following points:

A preference shareholder is a shareholder of the company. A debenture holder is a creditor of the company.

A debenture is usually secured on the assets of the company. A preference share is not secured since it is not a borrowing.

The coupon interest on the debenture is an expense to be paid by the company before calculating the profits on which tax has to be paid. Dividends on preference shares are paid from the residual profits of the company after all external liabilities, including tax, have been paid.

Three differences — status, security, and tax treatment. The third is the one most often missed: interest is deducted before tax; preference dividend is paid after it.

2.8 Rights issue of shares

A company may raise equity capital from its investors at various times. Whenever a company makes a fresh issue of shares, it has an impact on the existing shareholders since their proportionate holding in the shares of the company gets diluted.

The illustration: a company may have 10 lakh outstanding shares of Rs.10 each, amounting to an issued and paid-up capital of Rs. 1 crore. If it issues another 10 lakh shares, to increase its capital, the proportion held by existing shareholders will come down by half, as the issued and paid up capital has doubled. This is called as dilution of holdings.

The remedy: to prevent this, Companies Act requires that a company which wants to raise more capital through an issue of shares must first offer them to the existing shareholders. An existing shareholder has a right to proportionate participation in all capital raising activity. Thus the term Rights issue. A rights issue is subject to various SEBI regulations.

How it works: the rights shares are offered to the existing investors in a proportion as approved by the Board of the company. For example, the company may choose to issue rights at 1 for 1, to double its capital. This means each existing shareholders will get one equity share for every one equity share that they already hold. The issued and paid up capital will double, but proportionate holdings of each shareholder will not change.

Capital doubles; proportions stay the same — provided every shareholder takes up his entitlement, since the ratio and price of the rights issue is proposed by the Board of the company, however the participation in a rights issue is voluntary.

The timelines: in terms of Regulation 85 of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, Rights Issues shall be completed within 23 working days from the date of Board of Directors of the Issuer approving the Rights Issue.

Further Indicative timeline of broad activities involved in Rights Issue from the date of closure of Rights Issue till the date of listing and trading is prescribed by SEBI to be completed within 3 working days.

Twenty-three working days from board approval; three working days from closure to listing and trading.

2.9 Preferential issue

A company may issue shares to a strategic investor or collaborator at a pre-negotiated price. The pricing for such an issue is determined under various SEBI guidelines. A preferential issue dilutes (reduces) the proportionate rights of existing shareholders and thus requires approval of existing shareholders.

The contrast with a rights issue is exact. A rights issue preserves proportions and is offered to everyone; a preferential issue dilutes them and goes to a chosen investor — which is why it requires approval of existing shareholders.

The sample questions confirm that voting rights give the investor a say in management; that a 20 per cent dividend on a Rs. 10 face value is Rs. 2.00; that it is false that preference shareholders get preference over debenture holders; that dividend, bonus issue and stock split are all corporate actions; and that issuing additional shares to existing shareholders without capital contribution is a bonus issue.