A company raises external finance basically from two fundamental variants: Debt and equity. The debt is an essential component of the capital structure of a company. Apohan advises a company in formulation of its capital structure, in deciding the strategy for a loan, in deciding the amount, drawdown and expenditure schedule, interest rate; in negotiating the contract with the lenders. However, Apohan is not into the business of identification of lenders. It is looking for the opportunities to act as the direct selling agents or the channel partners of prestigious banks. For now, so, we will not look into the classification of debt instruments.
Latest look into what all types of equity instruments are available for a company to raise funds:
Most of the small and medium enterprises have only common equity held by a very few people. For the private limited companies, the number is limited to 200. God forbid, but if a company is liquidated, the common equity holders have the last rights on the proceeds of liquidation/disposal. Even during routine operations of a company, they have the last right on the the proceeds of sale. Dividend is paid only if the liability of every other stakeholder is fully met and adequate provisions have been made for the existence & growth of the company. Provided that it is going to be a successful business story, a fresh equity capital is the costliest form of funding available. A business has to share everything with the new owners in the proportion of their ownership. Unlike one can redeem a bank loan and get full control of company back; equity cannot be redeemed, at least technically.
When to issue new common equity? Issue of additional common equity will provide the ownership rights to the new participants that the old business owners would have. This results in dilution of the control. A company should issue equity if it is psychologically amenable to dilute its control on a company. The proceeds of the common equity can be used for any and every purpose of the company that the management feels appropriate. For a business in financial distress, it should raise common equity for financial turnaround and to run the facility at 100% capacity. For a business operating in high growth market, equity capital can be raised to undertake new projects and new marketing initiatives. Looking at it in another way, common equity should be raised when the banks are not lending, or are lending much less band requirement. It is a handy tool, when the institutional lenders cannot understand your business story and growth ambition.
There are two main aspects of ownership of a share. The financial benefit and the other is control of the company. Please note that control of the company, in one’s subjective opinion, has a lot of impact on the financial benefit from the company in long term future. Issue of differential voting rights is very much possible in small small and medium enterprises before the year of listing with less hurdles of corporate process.
This creates Three Types of shares: 1. Common shares – where one share can have one vote 2. Shares with fractional voting rights: Where one share has only a fraction of vote 3. Shares with superior voting rights: Where one share has multiple number of votes in the General Meeting of the company. Despite these differences, all the shares have same rate of dividend or any other financial benefit. Obviously, shares with fractional voting rights are cheaper and shares with superior voting rights are at premium.
When are differential voting right shares issued? The prevalent management of the company sometimes may like to give away the financial benefit in a larger proportion to raise more money but would like to retain the control in the decision making of the company. This is achieved through differential voting right share.
Some equity instruments mixed nature. They are basically equity instruments but also they have some characteristics of debt. These mixed characters are achieved by the terms in the contract giving various rights to the holders of the the equity instruments in the form of fixed guaranteed periodic returns. Company can create several classes of equity in its capital structure and give these different kinds of rights to the holders of the instruments or securities. One basic principle should be remembered: The lesser the risk taken by the capital provider, the lesser the returns he should get. There can also be an option of converting the preference shares into equity shares at some point of time in the future in a certain agreed proportion. Following are the types of of complex equity instruments:
Typically, preferred equity is a different class of equity and the holders of preference shares don’t have all the rights or at least the most important rights that the common shareholders have. Though they are shareholders,they cannot participate in the General Meeting (there could be a separate meeting for them) and they don’t have any say in the main decisions of the company. They are paid an agreed rate of dividend per annum which is liable to pay after all the the operational and debt liabilities are met. The preference equity is not for infinite time period like the common equity but it has a specific tenure. The advantage is that the payment of dividend is subject to availability of distributable profits. It may add to the liabilities of the next year or may expire.
When to raise preference equity? Unlike the bank, preference equity does not require any security north holders of preference shares will liquidate the company for payment defaults. Beard expectation of annual dividend rate is higher but the terms they offer are highly conducive than that of a bank loan.
Options are the instruments issued by a company for consideration of a option premium amount giving the buyers of them a right to buy a specified number of equity shares at a future date specified in the contract. Typically, options are issued by the shareholders of a company and are traded on stock exchanges. These options are listed on stock exchanges.
When are options issued? Their main objective to benefit from the price movement. The options are written by players to trade more volumes with less amount for a given total price of share.
Warrants are of the same nature as the options, however, instead of by the shareholders, they are issued by the company itself. They are not traded on the stock exchange. If the option holder exercise is the option, he becomes the shareholder of the company.
When are warrants issued? A company issues warrants to to attract more number of investors and to raise low cost capital.
There are many instruments which can be issued basically in the form of a debt or a loan, but they may have certain characteristics of equity. In the future the securities have impact on the capital structure of the company. One of the basic characters of such capital contracts is convertibility of the instrument. Under the terms and conditions of the contract, the debt security may get converted into equity type.
Convertible debentures are typically short term and they are not backed up by any security. They get converted into common equity in the specified manner of its terms and conditions.
When are convertible debentures issued? Convertible debentures are issued when there is no security to offered to the investors, and also the ability to pay higher interest on the amount raised is not there. In addition, treating the capital as loan gives tax benefits.
These are secured instruments and they get converted into common equity in the specified manner of its terms and conditions.
When are convertible bonds issued? The philosophy behind issue of convertible bonds is same as that of convertible debentures. However, the rate of interest on convertible bonds would be lower as it is a secured instrument.
Foreign currency convertible bonds (FCCB):
These are secured instruments issued in foreign currency by a company and in the same way as the domestic currency convertible bonds, they get converted into common equity.
When is money raised to foreign currency convertible bonds? If the interest rate benchmarked with the LIBOR is much lower than the domestic interest rate, it makes a good sense to raise capital through foreign currency convertible bonds. Since the bonds are nominated in a foreign currency and the local operations generate money in local currency, the company has to manage foreign exchange risk.
All above are means of how a company raises capital through various types of equity instruments. Apohan carries out professional, end-to-end, customized consultancy services under above classification of equities to achieve the objectives of the business. Apohan carries out all these equity transactions, right from the problem identification phase, to the closure of deal with perfection.
Apohan understands the purpose & modalities of these types of equities/ securities. Not only app and select the right kind of equity, apohan also understands the aspects of the equity instruments and their implications on the business. We help a business in issue of any of all these types of securities.