This article is written by Janhavi Shringarpure who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
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Corporate finance practices over the world have been ramping up to tune in with the requirements of the current business growth strategies. The two foremost ways of securing capital include debt financing by borrowing public funds and equity financing through selling shares and raising finance by fetching equity investors. The foremost step in capital decision making is to decide the quantum of external capital required for its operations, examine the financial markets and their favorability in raising finance and accordingly choosing an optimal mix or ratio of debt and equity for their capital structure.
Raising equity capital is selected as the foremost financial strategies for emerging business ventures. The simple reason being, that unlike debt capital, the company does not have the loan repayment obligation instead, the cost of equity capital is tantamount to the return on investment that the shareholders generally expect based upon the performance of the entity and the larger market. This, in turn, gives an incentive to the companies as they can channel more money into growing the business. Furthermore, common stock gives stockholders voting rights but doesn’t give them much else apart from capital appreciation.
According to the Goldman Sachs report on stock financing, “Equity financing through sale of shares have persistently been accelerating drivers representing a strategic growth opportunity and competitive necessity for firms.”
Due to the foregoing reasons, businesses are inclined towards choosing equity finance through issuing shares as a fundamental part of their corporate finance strategy.
This article delves into the process of equity financing by issuing stocks and its particularities.
Equity financing and its advantages
Equity financing involves selling a portion of a company’s ownership in return for capital. For example, the owner of Company XYZ might need to raise capital for funding a new product launch or entering a new market segment. The owner decides to give away 10% of ownership in the company and sell it to an investor in return for capital infusion. That investor now owns 10% of the company and has certain rights such as voting rights for the business decisions and an entitlement to the profits of the company in proportion to his investment.
The main advantage of equity financing for the company is that there is no personal liability on the part of the founders or promoters to repay the money acquired through it. Though they have an obligation to provide the equity investors with a good return, they will not have stringent timelines for payment of principal amount or interest charges as is the case with debt financing. In case of any losses, the promoters do not become personally liable to the investors for repaying the original amount. As a result Equity financing does not place a financial burden on the company.
However, equity financing comes along with numerous downsides as well. In order to gain funding, you will have to give the investor a percentage of your company. This could be a potential downside since the rewards earned and deserved by the company would fill the pockets of investors and any decisions affecting the company would require prior consultation and approval from the investors or shareholders. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.
That being said, equity financing is one of the most sought methods of raising funds and has a substantial upside potential provided the deals are negotiated the right way.
Alternatives available for equity finance by the way of issuing stocks
An entity has multifarious options for equity financing. Generally, angel investors or venture capitalists are inclined to take a stake in the entity and infuse the capital during the early growth stages of a business. Furthermore, a company can choose to make an Initial Public Offer and list its stocks on the market. Public offering has innumerable benefits for a company besides just raising capital and funding the operations.
Process for public issue
One of the most common methods of equity financing by the way of issuing stocks, is by making a public issue seeking listing of such securities on a recognized stock exchange. An Initial Public Offering or IPO is the first issue of shares by a private company. When a company decides to go public, it offers shares at a pre-determined price/price-band through the IPO.
Investors get an opportunity to become shareholders in the company and earn dividends if the company profits as well as capital returns if the demand for the shares of the said company increases. Another added advantage is that public stock is essentially a form of currency that can be bought and sold at a market price at any moment, which can be helpful when compensating employees and acquiring other businesses.
Apart from that, going public elevates the prestige and public image of the company and increases the brand awareness and visibility due to high exposure. Besides helping attract better management and employees through liquid equity it also creates opportunities to increase and diversify the equity base.
Going public is a milestone for a company since its one of the biggest events in the corporate life of an entity. The entire process of an IPO entails complex procedures and activities. The SEBI (ICDR) Regulations govern the issue of new stocks and compliance with these regulations becomes mandatory on the part of the issuer.
IPO process in accordance with SEBI (ICDR) Regulations:
- Check the eligibility criteria for making an IPO.
- Appointment of lead managers and other SEBI intermediaries.
- Share prices to be determined in consultation with lead merchant banker (fixed price) or through book building process.
- Filing of prospectus/offer document with the Stock exchange.
- Pre-issue advertisement of offer document in English, Hindi newspapers.
- Appointment of underwriters to subscribe a selected portion in the event of under subscription.
- Promoters shall bring minimum contribution one day prior to opening of the issue (generally 20% of post-issue capital).
- The issue shall be open for minimum of 3 days and maximum of 10 days.
- The issuer shall receive at least 90% of the offer size as minimum subscription.
- Deciding basis of allotment, completing the allotment process.
- If shares are not allotted to any applicants, then any application money received on such shares shall be refunded to the applicants.
- Post-issue advertisement.
- Other post-issue compliance.
Documentation checklist IPO
- Certified copies of the updated Memorandum of Association and Articles of Association of Company as amended from time to time.
- Certificate of Incorporation of Company.
- Certificate of commencement of business.
- Copies of the Board and shareholders resolutions authorizing the Issue.
- Report of the Statutory Auditors/Peer Review Auditor on Company’s Restated Financial Statements (Standalone) for past 3 financial years and stub period not older than 6 months from the date of filing & opening of IPO.
- Report of the Peer Review Auditor on Company’s Restated Financial Statements (Consolidated) for past 3 financial years and stub period not older than 6 months from the date of filing & opening of IPO.
- Statement of Tax Benefits from Chartered Accountants.
- Copies of annual reports of Company for the past three (3) Financial Years.
- Consents of Statutory Auditors, Peer Review Auditors, Bankers to Company, Merchant Banker, Registrar to the Issue, Legal Advisor to the Issue, Directors of Company, Company Secretary and Compliance Officer, as referred to, in their respective capacities.
- In-principle approval from the Stock Exchanges for listing of the securities.
- Due Diligence certificate to SEBI from the Merchant Banker.
- Observation Letter issued by the Securities and Exchange Board of India and reply to the observation by Merchant Banker.
Process for raising funds through venture capital
Another common form of raising equity finance, apart from public issue, is via Venture Capital. Venture Capital (VC) financing may be a method of raising money via high net worth individuals who are watching diverse investment opportunities. They provide the corporate with much-needed capital to sustain business in exchange of shares or ownership within the company.
A start-up might need various rounds of equity financing to satisfy liquidity needs. They (VC) may like to go for convertible preference share as form of equity financing, and as the firm grows and reports profit consistently, it may consider going public.
If the company decides to go public, these investors (Venture Capitalists) can use the opportunity to sell their stake to institutional or retail investors at a premium. If the corporate needs additional cash, it can choose the right offer or follow on public offerings.
When a company goes for equity financing to meet its liquidity needs, for diversification or expansion purposes, it has to prepare a prospectus where financial details of the company are mentioned. The company has got to also specify on what it plans to try to to with the funds raised.
Process of raising funds through venture capital:
- Conduct business valuation for your start-up.
- Ascertain the funding requirements for negotiating the deal.
- Develop a suitable business plan and prepare the pitch deck.
- Gathering the necessary documents.
- Make a list of the target venture capitalists.
- Network your way through meet-ups and pitch in for securing a good deal.
- Negotiate term sheets.
- Carry out the due diligence process.
- Closing the deal.
The fulcrum of the corporate journey of any business is to choose an optimal mix of funds either by the way of equity or debt to sustain the growth in a long run. Equity financing by the way of issuing stocks is one of the most preferred corporate finance options due to a bundle of reasons. The rights and privileges that equity ownership entails, offers good incentives to investors that ultimately yields better returns for them in the long run.
While there are a plentitude of advantages with issuing equity stocks, there are also certain downsides such as dilution of ownership and operational control, lack of tax shields, potential conflicts with the investors or shareholders etc. In order to arrive at an ideal corporate finance structure, one needs to carefully weigh the costs and benefits of equity financing and then make a shrewd decision.
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