This article is written by Aura Das, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho. The article has been edited by Zigishu Singh (Associate, LawSikho) and Ruchika Mohapatra (Associate, LawSikho).
Table of Contents
Introduction
India’s capital markets are on a lifetime high, with stock market indices touching unreal numbers every day. This bull market phenomenon can be attributed to multiple factors like reduced barriers to market access, the rise of tech/cloud-based businesses and a boom in the startup industry with more and more businesses getting higher valuations from venture capitalists and institutional finance organizations. This is helping fuel the current investment surge by the Indian public and foreign investors alike. As more and more unicorns look to raise their capital from the stock markets, we will attempt to understand what are the different types of capital markets in India and how they work.
What is a primary market?
The primary market is a part of the capital market which helps in the creation of securities for its sale to the public. It is in the primary market that securities are created or new securities are issued for the first time to be purchased by the investors. This is generally a way of raising capital by the companies by issuing securities in a recognized stock exchange.
The primary market has no physical existence and exists in the form of stock exchanges. It provides for the origination, underwriting and distribution of securities. Origination involves assessing and creation of new securities. Underwriting is the process wherein a bank or any financial institution acts as a medium between the issuers and the investors. The selling of the securities to new investors is referred to as distribution.
The company issuing the securities, the underwriter and the investor are the three entities that are involved in the functions of a primary market. The primary market is also known as the new issue market since securities are issued for the first time in a primary market through an Initial Public Offering. The sale price is determined by the underwriters, who also facilitate the new issue offering. Investors then purchase the new securities in the primary market. Issuance of securities can take place in the form of public issues, private placements, rights or bonus issues. Securities can be issued at face value, premium value or par value. After the securities are issued in the primary market, trading of the securities begins in the secondary market.
The Securities and Exchange Board of India (SEBI) is the government regulatory body that regulates the primary market. The main purpose of companies for issuing securities in the primary market is to either expand their business operations, funding of their business or extend their physical presence in the market. Securities issued through a primary market involve stocks, corporate or government bonds, notes and bills.
What is a secondary market?
The securities after being initially offered to the public in the primary market are traded in the secondary market. The secondary market constitutes the equity market and the debt market. The secondary market provides an efficient platform for trading securities for any investor. It is also considered as an equity trading platform wherein pre-existing or pre-issued securities are traded amongst investors. The secondary market can either consist of the stock exchange, which is the part of an auction market or Over-the-Counter( OTC) which is a part of the dealer market. It is different from the primary market as the primary market deals with raising capital or funds by offering the securities to the public for subscription to investors
There are various departments of SEBI that regulate the activities in the secondary market such as the Market Intermediaries Registration and Supervision Department (MIRSD) which deals with registration, compliance, supervision and inspection of market intermediaries with respect to all segments of markets, the Market Regulation Department (MRD) which formulate new policies and supervise the functioning and operations of securities exchanges, their subsidiaries and market institutions and Derivatives and New Products Department( DNPD) which supervise trading at derivatives segments of the stock exchange, introduce new products to be traded and consequent policy changes. The types of securities dealt in a secondary market are equity and debentures.
What is equity?
Equity shares are the units that basically constitute the capital of the business. Investors who subscribe to the equity shares of a company by contributing to the total capital of the business become the shareholders of the company. The shareholders then become eligible to get returns of their investment from the company. Investors who invest in equity are rewarded in the form of dividends and capital appreciation. Dividends are paid out of the profit made by the company and capital appreciation is a long term benefit that is received once the business runs successfully for a considerable amount of time. Investments in equity is a risk as long as there is an assurance of generating long term profits. Equity shareholders also get voting rights in the matters of the company and their ownership is limited to the extent of the shares held by them.
Equity investment in the primary and secondary market
Equity capital markets or ECM are the places where financial institutions help companies to raise funds. The ECM consists of primary and secondary markets. In the primary market, there are four ways by which investors can help in raising funds by buying securities. They are as follows:
Initial Public Offering (IPO)
This is a fast way of raising capital for a company by making its shares available to the public for the first time. For making an initial public offer, the companies need to get listed on a public stock exchange as per the guidelines of the SEBI. This is a risky option for the investors as there is a high chance of the company not performing well once it gets converted to a public company. It can be a profitable investment if the company performs well.
Rights issue
By this process, new shares are created while restricting investor access to the shares. A company generally offers new shares to certain investors or to its existing employees. ESOPs (Employee Stock Options) is an example wherein the shares get vested with the employees after the employees complete a specific period of employment. The investors can exercise their rights of being the shareholder of the company and also have the option to sell the rights of the shares to someone else.
Private placement
In this case, new shares are offered to a small group of investors, which can be institutional investors or certain individuals. Generally, High Net worth Individuals (HNIs) are sought by companies to offer their shares. It is different from an IPO since the shares are not open to public offers. This is an easier and faster way for start-ups and early-stage companies to raise funds as it involves fewer regulatory requirements as compared to other methods.
Preferential allotment
This is very similar to private placement as in this case, shares are offered to a select group of investors. They can be anyone and do not necessarily need to have any connection to the company. In this case, companies can control the transfer of shares to other investors.
With respect to the Companies Act, 2013, offering any kind of security on a private basis that attracts provisions of Section 42 is called Private Placement of Securities whereas allotment of equity shares or securities convertible into equity shares attracts both Section 42 and 62(1)(c) and called as Preferential Allotment of securities. It can also be said that preferential allotment involves the private placement of equity shares or convertible securities.
The secondary market is often known as the stock market where investors trade among themselves. Previously issued securities are traded here without involving the companies. The secondary market can be further divided into two categories:
Auction market
In the auction market, the prices at which the individual or institutional investors are willing to buy or sell are announced by them, which are known as bids and ask prices. In this scenario, all the parties come together and publicly declare their prices. This convergence helps the buyers and the sellers to mutually agree on a price. The best example is the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).
Dealer market
In the dealer market, parties need not be present in a particular location. Rather they are connected through electronic networks. The inventory of the securities is dealt with by the dealers who manage the selling and buying of the securities by the participants. The profit earned by the dealers is the difference between the prices of selling and purchase. The competition in the dealer market provides the best price for the investors.
Conclusion
Raising capital through equity markets has numerous advantages. Companies do not have to access debt markets which are expensive in order to raise capital to finance future growth. Equity markets are also relatively more flexible and have a greater variety of financing options for growth as compared to debt markets. In some instances, especially in a private placement, equity markets also help entrepreneurs and company founders bring in experience and oversight from senior colleagues. This will help companies expand their business to new markets and products or provide needed counsel. The process of the public offer can be a disadvantage as it is time-consuming and involves a lot of regulatory compliance as per the guidelines of SEBI. Investors who are more tolerant to business risks may choose equity investment as a suitable option, as abandoning the shares may produce negative results due to the drop in shareholding of the company.
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