How Companies Raise Money
Some 30 companies have decided to list their shares on the Karachi Stock Exchange. But why? What do they get out of it? There are, after all, tremendous costs involved in gaining a stock market listing and maintaining it.
Quite simply, listing on the stock market is all about raising money to enable your business to expand. Imagine you have a brilliant idea for a new company but you don’t have the money necessary to buy equipment such as computers and office furniture. You might initially think about raising some money from family and friends and giving them a stake in your business in return. This is, in fact, the way many companies start life. Shares issued by companies not listed on the stock exchange are often referred to as ‘unquoted’.
But if you need money on a large scale or you are a small business looking to expand, you might need more than your close acquaintances can provide. At this stage some people look to borrow money from venture capitalists or the bank. Others decide to try and raise money from a wider group of investors through a stock market listing. These shares are known as ‘quoted’ or ‘listed’ on the stock exchange.
It is rare, however, that companies approach the market just once for money. As you flick through the financial pages of your newspaper you will often read about rights issues, share splits and share buy backs. These are all terms used to describe different ways companies raise money from investors and, pay it back.
Stock splits and scrip issues
Raising money by issuing shares is a viable option for a company because investors have to rely on the company’s performance in the future to get their money back. If the company borrowed money from the bank instead they would have to make interest repayments on set dates.
A company that decides to raise money by issuing shares is said to be ‘floating’ on the stock market but this option is not open to all companies. It has to seek approval from various regulators and banks before asking the public for money. It also has to issue a prospectus, which explains what the company does why it is raising money and what opportunities and risks there are to investors from buying shares in the firm.
When you buy shares through an IPO you are buying them on what is known as the primary market. New issues of shares are distributed through a broker appointed by the company and are sold at a fixed price. Investors sometimes buy shares in a new issue hoping to sell them immediately at a profit rather than hold them. These investors are known as ‘stags’.
Once the new issue is completed and the company is officially listed on the stock market, it is known as a public limited company (plc) and shares can be traded between investors. This is known as the secondary market. Shares sold on the secondary market trade for whatever someone is willing to pay for them. The more valuable a company is perceived to be, the more investors are prepared to pay for it and vice versa.
If a company does not want to issue shares, it can issue bonds instead. Bonds are different to equities because rather than investors having to rely on the company’s returns to make money, the company pays a fixed sum back to investors every year. It also promises to repay the full amount it borrowed after a set number of years.
This way of
raising money is called issuing debt as the company is effectively borrowing money from you.
A public limited company is free to go back to the market whenever it pleases to ask for more money. This is known as a rights issue. You are not, however, under any obligation to take up its offer.
Companies decide to raise more money for a variety of reasons but usually it is to fund expansion, perhaps to take over a rival or to diversify into a new business area. Rights issues are almost always offered to existing investors and the amount they are offered depends on how many shares they already own. They could, for example decide to issue two new shares for every one held.
Shares offered under a rights issue are usually offered at a discount, often between 20% and 40% of the current share price. Existing shareholders receive a Provisional Allotment Letter which tells them how many shares they are entitled to and what the price will be.
If you receive this letter you can either take up the offer or decide to sell the letter onto another person who can subscribe for the shares instead. This is known as ‘rights nil paid’. Another option is to do nothing. If you do this the company will sell the shares in the market, retain the subscription price and remit any excess proceeds from the sale to you.
You should remember that once a company has issued extra shares, you own a smaller proportion of it and so your shares should be worth a little less. How much less will depend on how much other investors are prepared to pay for them.
Companies can also issue new shares through a placing. This is when new shares are created and sold through the company’s financial adviser, usually at a price just below the price of the existing shares.
Stock splits and scrip issues
Companies can decide at any time to increase the number of shares they have in issue by doing a ‘stock split’. This often happens when a company decides its share price has got too high and is concerned that trading will decline as a result. If a stock splits and, for example, give you two shares for every one you own, there is no real change in the value of your holding, even though you own more shares.
Another way for companies to issue more shares is through a ‘scrip issue’. This happens when a company decides to turn part of the reserves it has accumulated into new shares. These shares are usually issued to existing holders but are not, as many people mistake them, free shares. The company is simply moving its money from one part of the balance sheet to another.
Share buybacks and special dividends
Companies have to have a certain amount of money in reserve to protect the business if, for example, profits were to collapse. If the company has done very well for a number of years it can build up excess reserves. It may decide to use this money to fund an acquisition or may pay a special dividend to investors.
Alternatively, it might choose to buy back some of its own shares. When a company buys back its own shares it makes the shares still in issue more valuable. Say, for example, a company has 100 shares worth Rs.100 each and you have five shares, you own 5% of the company. If it buys back and cancels 20 of those shares, you still own five but your stake in the company has increased to 6.25%.Source: worldtradingnews.blogspot.com