Equity finance - introduction

Author: Jim Riley Last updated: Sunday 23 September, 2012

Introduction to share capital (equity)

Introduction

What is equity?

Equity is the term commonly used to describe the ordinary share capital of a business.

Ordinary shares in the equity capital of a business entitle the holders to all distributed profits after the holders of debentures and preference shares have been paid.

Ordinary ( equity) shares

Ordinary shares are issued to the owners of a company. The ordinary shares of UK companies typically have a nominal or 'face' value (usually something like £1 or 5Op, but shares with a nominal value of 1p, 2p or 2Sp are not uncommon).

However, it is important to understand that the market value of a company's shares has little (if any) relationship to their nominal or face value. The market value of a company's shares is determined by the price another investor is prepared to pay for them. In the case of publicly-quoted companies, this is reflected in the market value of the ordinary shares traded on the stock exchange (the "share price").

In the case of privately-owned companies, where there is unlikely to be much trading in shares, market value is often determined when the business is sold or when a minority shareholding is valued for taxation purposes.

In your studies, you may also come across "Deferred ordinary shares". These are a form of ordinary shares, which are entitled to a dividend only after a certain date or only if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary shares.

Why might a company issue ordinary shares?

A new issue of shares might be made for several reasons:

(1) The company might want to raise more cash

For example might be needed for the expansion of a company's operations. If, for example, a company with 500,000 ordinary shares in issue decides to issue 125,000 new shares to raise cash, should it offer the new shares to existing shareholders, or should it sell them to new shareholders instead?

- Where a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company, this is known as a "rights issue".

(2) The company might want to issue new shares partly to raise cash but more importantly to 'float' its shares on a stock market.

When a UK company is floated, it must make available a minimum proportion of its shares to the general investing public.

(3) The company might issue new shares to the shareholders of another company, in
order to take it over

There are many examples of businesses that use their high share price as a way of making an offer for other businesses. The shareholders of the target business being acquired received shares in the buying business and perhaps also some cash.

Sources of equity finance

There are three main methods of raising equity:

(1) Retained profits: i.e. retaining profits, rather than paying them out as dividends. This is the most important source of equity

(2) Rights issues: i.e. an issue of new shares. After retained profits, rights issues are the next most important source

(3) New issues of shares to the public: i.e. an issue of new shares to new shareholders. In total in the UK, this is the least important source of equity finance

Each these sources of equity finance are covered in separate tutor2u revision notes.