Equity shares, also known as ordinary shares or common shares, represent ownership in a company. They entitle the shareholder to a portion of the company’s profits (dividends) and a vote in company decisions.
What is Equity Shares?
Equity shares are the most common form of shares issued by companies. They signify a portion of ownership in the company, with the shareholder entitled to a share of the company’s profits and voting rights in proportion to the number of shares held.
Why Equity Shares made?
Companies issue equity shares to raise capital for various purposes, such as expanding operations, funding new projects, or paying off debt. Investors buy equity shares to potentially gain from the company’s growth through dividends and capital appreciation.
Types of Equity Shares
Equity shares can be categorized into several types based on different criteria. Here are the main types:
1.Ordinary shares :
The most common type of equity shares, providing voting rights and dividends to shareholders. These shares represent the basic ownership in a company.
Sure, here’s a simple and short example of ordinary shares involving four partners:
Example :-
Imagine you and three friends (Ram, Shyam, and Murlil) start a company. You decide to issue 100 ordinary shares to divide ownership equally among the four of you.
- Ownership : Each of you gets 25 shares (100 shares ÷ 4 partners).
- Voting Rights : Each share gives one vote in company decisions. You, Ram, Shaym, and Murli each have 25 votes.
- Dividends : If the company earns a profit and decides to pay $100 as dividends, each share gets $1. Therefore, each of you receives $25 (25 shares x $1).
Ordinary shares give you and your partners part ownership of the company, voting rights, and potential dividends.
2. Preference Shares: Though often classified separately, they are a type of equity share. They offer fixed dividends and have priority over ordinary shares in dividend payments and liquidation, but they usually lack voting rights. There are various subtypes of preference shares, including:
Example:-
Imagine you and three friends (A, B, and C) start a company. You decide to issue 100 shares: 60 ordinary shares and 40 preference shares. You and A each take 30 ordinary shares, while B and C each take 20 preference shares.
- Ownership:
- You and A each own 30% of the ordinary shares.
- B and C each own 20% of the preference shares.
- Dividends:
- Preference shares have a fixed dividend rate of $2 per share.
- If the company decides to distribute $120 as dividends:
- B and C, with their 20 preference shares each, receive $40 each (20 shares x $2).
- The remaining $40 is distributed among the ordinary shareholders. You and A each get $20 ($40 ÷ 2).
- Priority in Liquidation:
- If the company is dissolved and has $200 left after paying all debts:
- B and C, as preference shareholders, are paid first. If each preference share has a liquidation preference of $5, they receive $100 each (20 shares x $5).
- If there’s any remaining amount, it is distributed to ordinary shareholders (not applicable in this simple example as all $200 goes to preference shareholders).
- If the company is dissolved and has $200 left after paying all debts:
- Voting Rights:
- B and C, as preference shareholders, do not have voting rights.
- You and Alice, as ordinary shareholders, have voting rights in company decisions.
- Cumulative Preference Shares: Cumulative preference shares are a type of preferred stock that guarantees dividends. If a company misses paying dividends in any year, it must pay them in the future before paying any dividends to common shareholders.
Example:-
1. Company X issues cumulative preference shares with a 5% annual dividend.
2. In Year 1, Company X does not have enough profit to pay dividends.
The missed dividend of 5% is recorded.
3. In Year 2, Company X also does not pay dividends.
Another 5% is added to the owed dividends, making it a total of 10%.
4. In Year 3, Company X has enough profit to pay dividends.
Before paying dividends to common shareholders, Company X must first pay the 10% accumulated dividend to the cumulative preference shareholders.
This ensures that preference shareholders receive their owed dividends before common shareholders get any dividends.
- Non-Cumulative Preference Shares: Dividends do not accumulate if they are not paid in any year.
- Convertible Preference Shares : Can be converted into a predetermined number of ordinary shares.
- Non-Convertible Preference Shares :
Non-cumulative preference shares are a type of preferred stock where missed dividend payments are not carried forward. If the company skips a dividend payment, the shareholders do not have the right to claim it in the future.
Example:-
1. Company Y issues non-cumulative preference shares with a 5% annual dividend.
2. In Year 1, Company Y does not have enough profit to pay dividends.
The missed dividend of 5% is not recorded or carried forward.
3. In Year 2, Company Y has enough profit to pay dividends.
The company pays the 5% dividend for Year 2, but does not owe anything for the missed Year 1 dividend.
4. In Year 3, Company Y does not have enough profit to pay dividends again.
The missed dividend for Year 3 is also not carried forward.
So, shareholders of non-cumulative
preference shares do not receive any unpaid dividends from previous years.
- Participating Preference Shares :
Participating preference shares are a type of preferred stock that not only provide a fixed dividend but also allow shareholders to receive additional dividends based on certain conditions, usually linked to the company’s profits or dividends paid to common shareholders.
Example:-
1. Company Z issues participating preference shares with a 5% annual dividend.
2. In a profitable year, Company Z pays the 5% dividend to the preference shareholders.
3. Additionally, if the company declares extra dividends to common shareholders, the participating preference shareholders are entitled to receive an additional dividend on top of their fixed 5%.
– For instance, if Company Z decides to pay an extra 3% dividend to common shareholders due to high profits, participating preference shareholders will also receive this extra 3% in addition to their 5% fixed dividend, totaling 8% for that year.
This means participating preference shareholders benefit from both the guaranteed fixed dividend and potential extra earnings when the company performs well.
- Non-Participating Preference Shares:
Do not provide any rights to additional profits beyond the fixed dividend.
3. Bonus Shares : Free additional shares issued to existing shareholders based on the number of shares they already own. These are given out of the company’s reserves and do not involve any new investment from shareholders.
Example:-
1. Company A decides to issue bonus shares in the ratio of 1:2.
– This means for every 2 shares a shareholder owns, they will receive 1 additional share for free.
2. If you own 100 shares of Company A
You will receive 50 bonus shares (since 100 shares divided by 2 equals 50).
3. After the bonus issue:
You will now own a total of 150 shares (100 original shares + 50 bonus shares).
So, bonus shares increase the number of shares you own without you having to pay for them, effectively increasing your investment in the company.
4. Rights Shares : Rights shares are additional shares offered to existing shareholders at a discounted price, allowing them to maintain their proportional ownership in the company. Shareholders have the “right” to buy these shares within a specified time.
Example:-
1. Company B announces a rights issue in the ratio of 1:5 at a price of $10 per share.
This means for every 5 shares a shareholder owns, they have the right to buy 1 additional share at $10.
2. If you own 100 shares of Company B:
– You have the right to buy 20 additional shares (since 100 shares divided by 5 equals 20).
3. Current market price of Company B’s shares is $15:
– The rights shares are offered at a discount ($10 instead of $15).
4. You decide to buy the 20 rights shares:
– You pay $200 (20 shares x $10 each) to acquire the rights shares.
By purchasing the rights shares, you increase your total number of shares to 120 (100 original shares + 20 rights shares) and benefit from buying them at a discounted price.
5. Sweat Equity Shares : Sweat equity shares are shares issued by a company to its employees or directors at a discount or for consideration other than cash, in recognition of their work, expertise, or contribution to the company.
Example:-
1. Company C wants to reward its key 0
employee, Annu, for her significant contributions and hard work.
2. The current market price of Company C’s shares is $50 per share.
3. Company C issues 100 sweat equity shares to Annu at $10 per share (a discounted rate).
4. Annu receives these 100 shares for her efforts and contributions, without having to pay the full market price.
By issuing sweat equity shares, Company C rewards Annu with ownership in the company, motivating her and acknowledging her valuable contributions, while Annu benefits from receiving shares at a reduced cost.
6. Voting and Non-Voting Shares :
Voting Shares:- These are shares that give the shareholder the right to vote on company matters, such as electing the board of directors, mergers, or other significant business decisions.
Non-Voting Shares:- These shares do not provide the shareholder with the right to vote on company matters. They might still receive dividends and have ownership in the company, but they can’t influence the company’s decisions through voting.
Example:-
1. Company D has both voting and non-voting shares.
2. You own 50 voting shares and 50 non-voting shares of Company D.
3. Company D holds an annual general meeting (AGM) to elect new board members.
With your 50 voting shares, you can participate in the voting process to elect the board members.
Your 50 non-voting shares do not allow you to vote in this election.
4. Both types of shares might still receive dividends:
If Company D declares a dividend, both your voting and non-voting shares will receive it, but only the voting shares influence company decisions.
In this way, voting shares allow you to have a say in the governance of the company, while non-voting shares do not, even though both types can provide financial benefits like dividends.
How to Use Equity Shares
- Investing : Individuals buy equity shares to invest in a company they believe will grow and increase in value.
- Trading : Shares can be bought and sold on stock exchanges to benefit from short-term price fluctuations.
- Dividends : Shareholders may receive dividends as a return on their investment when the company profits.
How to Buy Equity Shares
1. Open a Brokerage Account : Choose a brokerage firm and open a trading account.
2. Research Companies : Use financial statements, news, and analysis to identify potential investments.
3. Place an Order : Use the brokerage platform to place a buy order for the chosen shares.
4. Monitor Investments : Regularly review the performance of your investments and make adjustments as needed.
Advantages of Equity Shares
Equity shares, also known as common shares, offer several advantages to both the shareholders and the issuing company. Here are some key advantages:
For Shareholders:
1. Potential for High Returns:
Equity shares can provide higher returns through dividends and capital appreciation compared to other investment options like fixed deposits or bonds.
2. Voting Rights:
Shareholders have the right to vote on key company decisions, such as electing the board of directors, mergers, and other significant policies, giving them a voice in the company’s governance.
3. Dividends:-
While not guaranteed, equity shareholders can receive dividends, which are a portion of the company’s profits distributed to shareholders.
4. Ownership:-
Owning equity shares means holding a part of the company. This can be a source of pride and also provides a claim on the company’s residual assets in case of liquidation after all debts and preferred shareholders are paid.
5. Liquidity:-
Equity shares of publicly traded companies are usually liquid, meaning they can be easily bought and sold on stock exchanges.
For Companies:-
1. Permanent Capital:
Equity capital is permanent. Unlike debt, it does not need to be repaid, providing a stable source of funds.
2. No Obligation to Pay Dividends:
Unlike debt, where interest payments are mandatory, paying dividends to equity shareholders is at the company’s discretion and can be omitted in poor financial periods.
3. Improves Creditworthiness:
Having a strong equity base can improve the company’s creditworthiness and make it easier to raise debt capital at favorable terms.
4. Increased Capital without Fixed Payments:
Raising funds through equity shares does not involve regular interest payments, thus preserving cash flow for other business needs.
5. Attracts Skilled Employees:
Offering equity shares or stock options can attract and retain skilled employees by giving them a stake in the company’s future success.
Overall, equity shares are beneficial for both investors looking for growth and companies seeking to raise funds without incurring debt.
Disadvantages of Equity Shares
While equity shares have several advantages, they also come with some disadvantages for both shareholders and the issuing company. Here are the key disadvantages:
For Shareholders:
1. Dividend Uncertainty:
Dividends on equity shares are not guaranteed and are paid only when the company makes a profit and decides to distribute it. In poor financial periods, shareholders may not receive any dividends.
2. Market Risk:
The value of equity shares can be highly volatile, influenced by market conditions, economic factors, and company performance. This volatility can result in significant losses.
3. Dilution of Ownership:
Issuing additional equity shares can dilute the ownership percentage of existing shareholders, reducing their control and potential dividends per share.
4. Residual Claim:
In the event of liquidation, equity shareholders are last in line to receive any remaining assets after all debts and obligations are paid, which might result in significant losses.
5. Lack of Control:
Small shareholders often have little influence on company decisions, as majority shareholders and institutional investors typically hold more voting power.
For Companies:
1. Cost of Issuance:
Raising capital through equity can be expensive due to underwriting fees, legal costs, and regulatory requirements involved in issuing shares.
2. Dividend Expectations:
While not obligatory, there is often an expectation to pay dividends, which can pressure the company to distribute profits rather than reinvest them for growth.
3. Dilution of Earnings:
Issuing more shares dilutes earnings per share (EPS), which might negatively impact the stock price and the perceived value of the company.
4. Loss of Control:
Selling equity can lead to a dilution of control, especially if a large number of shares are issued, potentially giving significant influence to new shareholders.
5. Disclosure Requirements:
Public companies are subject to strict regulatory requirements and must disclose financial information regularly, which can be burdensome and expose strategic information to competitors.
In summary, while equity shares provide benefits like raising capital without debt and offering growth potential to investors, they also come with risks such as market volatility, dilution of control, and regulatory burdens.
Conclusion
Equity shares are a fundamental investment vehicle that offers the potential for significant returns and ownership in a company. While they provide benefits like voting rights and dividend income, they also come with risks, including market volatility and potential financial loss. Investors should carefully research and consider their risk tolerance before investing in equity shares.