Last Updated on May 24, 2022 by Aradhana Gotur
Equity shares are one of the mainstays of businesses today. The promoters or owners arrange for the maiden source of capital to fund the initial set-up and kickstart of businesses. But promoters have their limits; they cannot finance all the expansionary motives of the company. And companies need funds to grow. This is where equity share capital comes into prominence. In this article, we break down the meaning of equity share capital and its features.
Table of Contents
What is equity share capital?
To meet the requirement of funds, companies seek out investors and issue them equity shares. The capital raised by issuing such shares is referred to as equity share capital. Equity shares once issued become a continuous source of funds for the company and are not paid off or redeemed until an event of liquidation of the company. In the meantime, equity shareholders enjoy a claim to a share of the net profit through dividends and become part-owners in the company equivalent to their amounts of share purchase. Even in the event of liquidation, they are entitled to a share of the residual assets.
Why do companies issue equity shares?
Having tackled the question of equity shares meaning let’s move onto the need for companies to issue equity shares. The obvious answer is to raise capital for business growth and expansionary motives. But why equity shares and why not debt financing? This is because raising capital through debt is akin to a dangling sword, you need to repay the debt along with interest, also your debt-to-equity ratio takes a plunge as you borrow more. There is no such repayment obligation in the case of equity financing, moreover, it is at the company’s discretion to pay a dividend; it is not a liability.
Below are some common reasons why companies issue equity shares:
- Raising capital to start a business (Private Equity)
- To finance diversification, acquisition, expansion, and strategic alliances
- Opportunity for family and friends of the promoters and founders to buy stakes
- Paying outstanding debt owed by the company
- Creating a sustainable cash reserve for future
Why do investors invest in equity shares?
An investor is always looking to earn money, and investing in equity shares is one of the fastest buses to a higher financial altitude.
Investors buy equity shares in the company, banking on the company’s potential to achieve tremendous success—the longing to reap the appreciation in the stock price.
Investors buy equity shares:
- To avail attractive dividend payouts
- To be eligible to receive bonus and rights shares
- As a cover against inflation (as equity is one of the best performing asset classes)
- Adding a fair share of equity to diversify their investment portfolio
- Be a part of the decision making of the company by receiving voting rights
Types of equity shares
Authorized share capital: It is the maximum amount of capital a company can raise by issuing shares. The company may decide not to issue the total capacity and even increase the authorized share capital complying with certain legal formalities.
Issued share capital: That part of authorized share capital for which applications are invited from the public.
Subscribed share capital: The amount of issued share capital subscribed by investors, i.e., shares agreed to pay for when asked.
Paid-up capital: It constitutes the actual capital invested in the business. It is the portion of subscribed share capital for which investors pay their agreed sum to the company.
Bonus shares: Also known as scrip issue or capitalization issue. Bonus shares do not involve any cash flows; they are issued out of retained earnings to bring employed capital of the company in line with the issued capital. If a company makes profits, the capital employed increases; to offset this increase, additional shares are given to the existing shareholders free of cost instead of increasing their current stakes.
Rights shares: As described under Section 62 (1) of the Companies Act 2013, rights shares are issued to extend a pre-emptive right to the existing shareholders to buy additional shares in the company at a discounted price. However, as the name suggests, rights shares offer only a right and are not an obligation; shareholders are well within their capacity to decline the invitation.
Sweat equity shares: Section 2 (88) of the Companies Act, 2013 defines sweat equity shares as shares issued to existing employees and directors for their hard work towards the company. Sweat equity shares are provided at a discounted price or for non-monetary considerations.
Features of equity shares
- Equity shares are an instrument of long-term financing
- Equity shares remain with the company as long as it’s a going concern and are only paid off in cases of liquidation or winding up of the company
- Equity shareholders enjoy the right to vote on matters of the company
- Equity shareholders enjoy limited liability. Their liability towards the company is fixed to the value of shares they’ve bought
- Equity shareholders are entitled to receive a dividend on surplus profits earned. However, the rate of dividend is not predetermined; there’s a possibility that no dividend is paid during a year at all
- Equity shareholders are given preference over potential investors during a further public placement of shares
- Though equity shares are irredeemable, they are transferable, and they can be used as an instrument of trading
Now when you know what equity shares are, let’s look at how they work.
How do equity shares work?
Equity shares are a win-win deal for both the company and investors. While the company meets its capital requirements, the shareholders get to become part-owners of the company. The company escapes the vicious clutches of debt financing, which would have been the other available alternative. As a result, the company doesn’t need to worry about repaying the capital raised during its lifetime.
The investors are happy because they are entitled to dividends, bonus shares, rights shares, and they are free to transfer their shares in the market as and when they wish to.
How to get mighty rich by investing in equity shares?
There are two approaches to make money by investing in equity shares that address the above question.
Investing in shares for short durations to earn some quick profit. The risk to reward ratio here is high. This investing strategy involves:
- Scalping: Profiting from the smallest of price changes multiple times a day.
- Intraday trading: Squaring-off trades within one trading session.
- Delivery trading: Holding trades for multiple trading sessions, generally for several days.
Investing in shares for a longer duration and holding stocks for years without reacting to market fluctuations. The risk involved remains the same as the underlying asset is the same, however, the potential for growth is greater as equity tends to perform well over longer durations.
Downsides of investing in equity:
Equity shares are not your sure-shot ticket to a more prosperous journey; they don’t come with a guarantee. They, too, have certain limitations.
From the company’s point of view:
- Equity shareholders need to be given voting rights, causing dilution of the control over management by the owner group
- Since equity shares are irredeemable, the capital structure of the company becomes rigid
- Equity financing provides no tax benefits to the company
From an investor’s point of view:
- If the company underperforms over the years, posts continuous losses, and doesn’t pay dividends, the equity shareholders might not even get their invested money back
- There’s nothing like fixed income; for instance, the dividend income
- Preferential shareholders have preferential rights over their equity counterparts
- With subsequent issues of shares, the voting rights of existing shareholders get diluted
The companies that we see today amassing thousands of crores of market capitalization wouldn’t have raised even a fraction of the capital they have without equity shares. Thus, equity shares play an important role in meeting fund requirements by the company and also help investors amass wealth over time. That said, it is prudent to assess your risk profile before adding equity to your investment portfolio.