Session 1: Equity Finance

Session Learning Objective
The Learners will understand how an ICT company can raise share capital by the use of equity source of finance

Important Learning Terms

• Equity
• Ordinary shares
• Primary market
• Secondary market
• Rights issue
• Stock exchange
• Bid
• Offer

Introduction
Equity finance is provided by the sale of ordinary shares to investors. This may be a sale of shares to new owners, perhaps through the stock market as part of a company seeking a quotation, or it may be a sale of shares to existing shareholders, for example by means of a rights issue.

Ordinary shares are bought and sold on a regular basis on stock exchanges all over the world. By law, the ordinary shares of a company must have a nominal, or par value and cannot be issued for less than this amount. The nominal value of a share bears no relation to its market value.

New shares, whether issued at the foundation of a company or subsequently, are almost always issued at a premium above their nominal value.

The Rights of Ordinary Shareholders
Ownership of ordinary shares confers rights on ordinary shareholders on both an individual and a collective basis. From a corporate finance perspective, some of the most important rights available to shareholders are the right to:

• attend general meetings of their company;
• vote on election of the directors of their company;
• vote on the appointment, remuneration and removal of auditors;
• receive the annual accounts of their company and the report of its auditors;
• receive a share of any dividend distributed;
• vote on important matters such as a change in their company’s authorized share capital, the repurchase of its shares, or take-over bid;
• receive a share of any assets remaining after their company has been liquidated;
• participate in a new issue of shares in their company (the preemptive right)

Stock Exchange
This is a market where securities are traded. These securities include ordinary shares, bonds, etc.
The Importance of a Well-run Stock Exchange

1. Firms can find funds and grow.
2. Allocation of capital.
3. Availability of a speedy, cheap secondary market for shareholders.
4. Enhancement of the Status and publicity for the company.
5. Mergers. Mergers can be facilitated better by a quotation.
6. Improves corporate behaviour.

The Primary and Secondary Markets
The primary market is where firms can raise new finance by selling shares to investors.
The secondary market is where existing securities are sold by one investor to another.
See the figure 1 and 2 below.

New Aspects in Equity Markets
There have been many changes and innovations over the past decades in the financial markets, especially in developed economies, regarding which shares are traded and how they are traded.

a) The Official List (OL)
Companies which wish to be listed have to sign a Listing Agreement which commits directors to certain high standards of behaviour and levels of reporting to shareholders. This is a market for medium and large established firms with a reasonably long trading history. The cost of listing is so high that small companies are unable to afford or to justify a full market listing.

b) Unlisted Securities Market (USM)
This is a second-tier market which was introduced to assist small and medium-sized firms to raise capital and to provide a liquid secondary market. The requirements for admission to the USM are less onerous than for the OL.

c) The Alternative Investment Market (AIM)
The driving philosophy behind AIM is to offer young and developing companies access to new sources of finance, while providing investors with the opportunity to buy and sell shares in a trading environment. Costs are down and the rules as simple as possible. AIM companies are expected to comply with strict rules regarding the publication of price-sensitive information and the quality of annual and interim reports. Upon floatation a detailed prospectus is required.

d) Trade points
Trade points allow those who want to buy or sell shares to bypass the usual system of going through a market maker. On trade points they can advertise their orders directly and anonymously via computers screens. Share dealing is carried out automatically by a simple mouse-click in a windows-based computer system. Trade point’s central computer is able to match buy and sell orders automatically and at relatively low cost.

e) Internet
The Internet has led to two main changes. First, real-time prices of shares and financial software to analyse equities markets, which were once exclusively available to the large, well-funded financial institutions are today accessible through a modestly priced personal computer, modem and software. This has put millions of small investors in up-to-the-second contact with the markets. Second, trading in shares over the Internet is now possible

Trading Systems
There are basically two different trading systems: the quote driven and the order-driven systems.

Quote-driven Systems
A share trading system in which one market maker quotes a bid and another market maker quotes an offer price for shares. This remains the dominant trading system in the world. The “bid” price is the price at which the market maker is willing to buy and the “offer” price is the price at which the market maker will sell (see figure 3).

The difference between the two prices, called “the spread”, represents a hoped-for return to the market maker. The market makers are obliged to deal (up a certain number of shares) at the price quoted, but they have the freedom to adjust prices after deals are completed. The investor or broker (on behalf of an investor) is able to see the best price available and is able to make a purchase or sale.

Order-driven Systems
A share trading system in which investors’ buy and sell orders are matched without the intermediation of market makers.
This is the most used system in the world that does not require market makers to act as middlemen. They allow buy and sell orders to be entered on a central system, and investors are automatically matched (they are sometimes called matched-bargain systems).
As figure 5 shows, the system works as follows: A subscriber (say, a broker acting for an investor client) advertises on their computer screen the price at which they will buy or sell a block of shares. If another subscriber wishes to accept the deal, all they have to do is tap their keyboard or mouse-click and the bargain will be struck as shown in figure 5 below. All trades are reported to all users on a “tape” which runs continuously along Trade point screens.

Raising Equity Capital
There are a number of alternative ways of raising finance by selling shares.

Authorized, Issue and Par Values
When a firm is created the original shareholders will decide the number of shares to be authorized (the authorized capital). This is the maximum amount of share capital that the company can issue (unless shareholders vote to change the limit). In many cases firms do not issue up to the amount specified.

Floating on the Official List
To “go public” and become a listed company is a major step for a firm. The substantial sums of money involved can lead to a new, accelerated phase of business growth. Obtaining a quotation is not a step to be taken lightly; it is a major legal undertaking.

The Stock Exchange rigorously enforces a set of demanding rules and the company will be put under the strain of new and greater responsibilities both at the time of floatation and in subsequent years

Prospectus
A company wishing to go to public is required to prepare a detailed prospectus to inform potential shareholders about the company. This may contain far more information about the firm than it has previously dared to put into the public domain.
A successful flotation can depend on the prospectus acting as a marketing tool as the firm attempts to persuade investors to apply for shares.

The Issuing Process
The issuing process involves a number of specialist advisers as shown in figure 6.
Figure 6 The Issuing Process for the Official List

The cost of new issues

1. Administrative/transaction costs
This has already been discussed earlier in the session. The amount of this cost may very much depend on the size of issue and the method used (figure 7)

2. The equity cost of capital
Shareholders suffer an opportunity cost. By holding shares in one company they are giving up the use of that money elsewhere. The firm, therefore, needs to produce a rate of return for those shareholders which is at least equal to the return they could obtain by investing in other shares of a similar risk class. If the firm does not produce this return then shares will be sold and the firm will find raising capital difficult.

3. Market pricing costs
This has to do with the possibility of underpricing new shares. It is a problem, which particularly affects offers for sale. The firm is usually keen to have the offer fully taken up by public investors. To have shares left with the underwriters gives the firm a bad image because it is perceived to have had an issue which “flopped”.

Rights Issues
A rights issue is an invitation to existing shareholders to purchase additional shares in the company. It is easy and relatively cheap (compared with new issues). Rights issues are generally very successful as shareholders are usually given strong incentives to act. The shares are usually offered at a significantly discounted price from the market value.
Shareholders can either buy these shares themselves or sell the “right” to buy to another investor. For further reassurance that the firm will raise the anticipated finance, rights issues are usually underwritten by institutions.

Example:
Suppose TeleCel Systems (T) Ltd, which has 10 million shares in issue wants to raise $ 25 million for expansion but does not want to borrow it. Assume that its existing shares are quoted on the stock market at $12. Assume further that ABC Ltd has decided that the $25 million will be obtained by issuing 2.5 million shares at $10 each. Thus the ratio of new shares to old is 2.5:10. In other words, this issue is “one-for-four” rights issue. Each shareholder will be offered one new share for every four already held.

What if the shareholder does not want to take up the rights?
Note: if the shareholder does not want to take up the rights, he/she can sell the rights on to someone else on the stock market (selling the rights nil paid).

Example:
Take the case of impoverished Mr. Maganga, who is unable to find the necessary $250 to purchase the 25 additional shares on offer at $10 per share. He could sell the rights to subscribe for the shares to another investor and not have to go through the process of taking up any of the shares himself. Or else the company can sell his rights to the new shares on his behalf and send him the proceeds. Thus, Mr Maganga would benefit to the extent of $1.6 per share or a total of $40 (if the market price stays constant) which adequately compensates for the loss on the 100 shares he holds. But the extent of his control over the company has been reduced – his percentage share of the votes has decreased.

The value of a right on one new share is:
Theoretical market value of share ex-rights – subscription price
= $11.6 – 10.0
= $1.6

Other Equity Issues
a) Open offer
In an open offer, new shares are sold to a wide range of external investors on the condition that existing shareholders have the right to buy them at the same price instead. There are no nil paid rights to sell.

b) Acquisition for shares
Shares are often issued to purchase business or assets. This is usually subject to shareholder approval.

c) Vendor placing
If a company wishes to pay for an asset such as a subsidiary of another firm or an entire company with newly issued shares, but the vendor does not want to hold the shares, the purchaser could arrange for the new shares to be bought by institutional investors for cash. In this way the buyer gets the asset, the vendor (for example shareholders in the target company in a merger or take-over) receives cash and the institutional investor makes an investment as shown in figure 8.

d) Script Issues
Script issues do not raise new money: a company simply gives shareholders more shares in proportion to their existing holdings. The value of each shareholding does not change, because the share price drops in proportion to the additional shares. They are also known as capitalization issues or bonus issues. The purpose is to make shares more attractive by bringing down the price. Note that with a script issue there will be some adjustment necessary to the balance sheet.

e) Warrants
Warrants give the holder the right to subscribe for a specified number of shares at a fixed price at some time in the future.

Equity Finance for Unquoted Firms
Not every company (especially the relatively small and medium firms – SMEs) has the opportunity to have an access to the Stock Exchange. Thus, it is in line to consider some of the ways that unquoted firms can raise equity capital.

The Financing Gap
Unquoted firms usually rely on retained earnings, capital injections from the founder and bank borrowings but in most cases these are not enough to finance growth aspirations. Thus, between large firms with access to the stock market and small firms financed by internally generated funds and personal and bank loans there is a financing gap (see figure 9). This aspect confronts intermediate businesses which find themselves too large or too fast growing to ask the individual shareholders for more funds or to obtain sufficient bank finance, and they are not ready to launch on the stock market.

How the financing gap can be filled?
a) Business Angels
Business angels are wealthy individuals, generally with substantial business and entrepreneurial experience who usually invest substantial amounts primarily in start-up, early stage or expanding firms.
The majority of investments are in the form of equity finance but they do purchase debt instruments and preference shares. They usually do not purchase a controlling interest, and they are willing to invest at an earlier stage than most formal venture capitalists (sometimes they call themselves “informal venture capitalists” instead of business angels). They are generally looking for entrepreneurial companies which have high aspirations and potential for growth. Business angels are generally patient investors willing to hold their investment for at least a five year period. The main way in which firms and angels find each other is through friends and business associates, although sometimes informal networks may be of help.

b) Venture Capital
Venture capital funds provide finance for high-growth-potential unquoted firms. Venture capital is a medium- to long-term investment and can consist of a package of debt and equity finance. Venture capitalists take high risks by investing in the equity of young companies often with a limited (or no) track record. Many of their investments are into little more than a team of management with a good idea – which may not have started selling a product or even developed a prototype.

There are a number of different types of venture capital (VC):

1. Seedcorn – This is financing to allow the development of a business concept. Development may also involve expenditure on the production of prototypes and additional research.
2. Start-up – A product or idea is further developed and/or initial marketing is carried out. Companies are very young and have not yet sold their product commercially.
3. Other early-stage – Funds for initial commercial manufacturing and sales. Many companies at this stage will remain unprofitable.
4. Expansion – Companies at this stage are on to a fast-growth track and need capital to fund increased production capacity, working capital and for further development of the product or market.
5. Management buy-outs (MBO)– Here a team of managers make an offer to their employees to buy a whole business, a subsidiary, or a section so that they own and run for it for themselves. Large companies are often willing to sell to these teams, particularly if the business is under-performing and does not fit with the strategic core business. Usually the management team have limited funds of their own and so call on venture capitalists to provide the bulk of finance.
6. Management buy-ins (MBI)– A new team of managers from outside an existing business buy a stake, usually backed by a venture capital fund. A combination of an MBO and MBI is called a BIMBO – buy-in management buy-out – where a new group of managers join forces with an existing team to acquire a business.

There are a number of different types of VC providers:

1. The independents – these can be firms, funds or investment trusts which have raised their capital from more than one source. The main sources are pension and insurance funds, but banks, corporate investors and private individuals also put money into these funds.
2. Captives – these are funds managed on behalf of a parent institution (banks, pension funds, etc.).
3. Semi-captives – these invest funds on behalf of a parent and also manage independently raised funds.

c) Venture Capital Trusts (VCTs)
These are special tax-efficient vehicles for investing in small unquoted firms through a pooled investment. They offer investors a way of investing in a broad spread of small firms with high potential, but with greater uncertainty, in a tax-efficient manner.

d) Corporate Venturing
Larger companies sometimes foster the development of smaller enterprises. This can take numerous forms, from joint product development work to an injection of equity finance.

e) Government Sources
The government may set up VC-type funds in order to attract and encourage industry. Equity, debt and grant finance may be available from these sources.