In capital markets, a firm can obtain funds in two ways. The most common method is to issue a debt instrument, such as a bond (Matthews et al., 2013). Similar to Governments, companies issue bonds, typically referred to as corporate bonds. They are a contractual agreement that compels a borrower (a firm) to pay the bondholder (an investor) interest at regular intervals and return the principal amount upon the bond's maturity. The second method of issuing funds is by issuing equities, i.e., a share in a company's ownership. A shareholder is entitled to receive an appropriate share of net income (income after taxes and expenses) paid in dividends and a business's assets. For example, if Sausage Roll plc has a total of 100 issued shares, and Mr. Greggs owns 10% or ten shares of the company, then he is entitled to one-tenth of the firm's net income and one-tenth of the firm's assets.
Shares of publicly listed companies are traded on the stock exchange, e.g., the London Stock Exchange (LSE) or the New York Stock Exchange (NYSE). By law, a private company cannot offer and sell its shares to the public. Although a public company must have the legal form of a 'plc' (public limited company) to have its shares listed, the listing process is entirely independent of the company registration process. It is not unusual for a plc to have no publicly traded shares. In the United Kingdom, the vast majority of companies are, in fact, private limited companies (99.2%), of which 99% are private companies limited by shares (MacIntyre, 2018). Private companies can also be limited by guarantee but only account for 0.2% of the total number of private limited companies in the United Kingdom. Thus we will only refer to companies limited by shares in this article.
Companies limited by shares.
One of the requirements for a limited company to be incorporated is the statement of capital and initial shareholdings, required by s. 10(2) of the Companies Act 2006 to state the following (MacIntyre, 2018):
the total number of shares to be taken on formation by the subscribers to the memorandum;
the nominal value of those shares;
for each class of shares:
- particulars of the rights attached to the shares.
- the total number of shares of that class, and
- the total nominal value of shares of that class.
the amount to be paid up and the amount, if any, to be unpaid on each share.
In other words, every company limited by shares must have a share capital, which refers to the amount invested in the company for it to carry out its operations. Various shares indicate the different rights shareholders hold concerning the company's control, voting rights, or entitlement to dividends. For example, the dividend on preference shares is paid before anything is paid out to ordinary shareholders (Arnold, 2012). Also, preference shares usually carry no voting rights.
Ordinary shares
Ordinary shares represent the firm's equity capital and are a means of raising long-term finance to run a business (Arnold, 2012). Ordinary shares are sometimes known as equity shares or 'common stock’ in the United States. French et al. (2018) define ordinary shares with the following passage:
''If there is no prior limit on the amount which the holder of a share may receive in a distribution either as an annual dividend or as a distribution of surplus assets on winding up, the share is called an ordinary share (CA 2006, s. 560(1)) or an equity share (s. 548). The total nominal value of all the equity shares issued by a company is called its equity share capital (s. 548). Ordinary shares and securities convertible into ordinary shares are together called equity securities (s. 560(1)).''
For public companies whose shares are traded on the Stock Exchange, share capital is usually of great financial significance. An initial public offering (IPO) is the first sale of stock issued by a company. In other words, it is when a business decides to start selling its shares to the public. The company will determine how many shares it wants to offer, and an investment bank will suggest an initial price for the stocks based on the predicted demand for them. Such shares are then sold in primary markets before being traded on the secondary markets. In other words, primary markets are where these shares are first issued and sold, while secondary markets allow trading those shares that have already been in circulation.
The typical benefits of holding ordinary shares include voting rights, the return of capital on winding up, a share of annual profits (dividends), the ability to transfer shares (French et al., 2018). Ordinary shares are also called equities because people who own them are entitled to the equity in the company which has issued them (CISI, 2020). If a company goes into liquidation, ordinary shareholders are then the last people in line for any pay-out. In the first place, the company’s assets are sold to pay off its creditors, such as banks, suppliers, or bondholders. This means that ordinary shareholders may not receive any money at all.
Preference shares
A preference share is a share that entitles the holder to an annual dividend of a fixed amount per share (usually expressed as a percentage of the nominal value of the share), paid in priority to any dividend payments to other members (Mayson, French & Ryan, 2018). Thus, preference shares give their holders superior rights and security over and above ordinary shareholders (CISI, 2020).
Investors may want to obtain preference shares for the extra level of security. For instance, a firm must distribute dividends to preference shareholders before they do so to ordinary shareholders. If there is little money to go around, it may happen that ordinary shareholders will not receive any dividends at all. Preference shareholders also take priority when the company goes into liquidation. The downside of being a holder of preference shares is that the amount of dividends is usually fixed regardless of the company's profits and typically expressed as the percentage of the shares' nominal value. On the contrary, there is no limit on the returns an ordinary shareholder might receive. This is because preference shares are part of preference holders' funds but are not equity share capital. Preference shareholders also have limited voting rights. There are different types of preference shares. Definitions of each type were taken from the book "Financial Times Guide: Financial Markets (2012)" written by Glen Arnold.
Cumulative – if dividends are missed in any year, the right to receive the dividend is carried forward. This means that ordinary shareholders may wait to receive their dividends even longer.
Non-cumulative - if preference shares are non-cumulative, that means any unpaid dividends will not be accumulated and carried forward.
Participating – if preferences shares are participating, the shareholder is entitled to receive an increased dividend if a company has high profits.
Redeemable – the company has the right to redeem the shares at some point in the future on a fixed date or a time chosen by the company (CISI, 2020). When a company redeems shares, the shareholder returns the shares to the company and receives a sum of money in exchange, while the company cancels them to reduce the total issued share capital. '
Irredeemable – irredeemable preference shares have no fixed redemption date.
Convertible – a shareholder can convert their preferences shares into ordinary shares at specific dates and on pre-set terms (e.g., one ordinary share for every two preference shares).
Redeemable shares
A company issues redeemable shares with an agreement to buy back these shares from shareholders after a certain period or at a specified future date (CISI, 2020). French et al. (2018) define redeemable shares as follows:
"Redeemable shares in a company offer temporary membership of the company with repayment of the value of the shares (and in some cases a redemption premium) at the end of the period of membership. The shares are redeemed, and the membership comes to an end either after a fixed period or at the company's option, depending on the terms of redemption of the shares."
These shares can give a company's directors more flexibility to manage its long-term growth (CISI, 2020). Redeemed shares are retired and reduce the share capital of the firm. Public companies may issue redeemable shares only if authorised to do so by its articles (French et al., 2018), while private companies do not usually need such authority. However, the articles of association of private companies can restrict or exclude its issue if the company wishes to do so.
Dual-class shares
A company's articles of association may allow for creating different types of ordinary shares, which each class (e.g., class A shares or class B shares) enjoying different rights. If there is only one class of shares, each share will have the same right to vote. However, different classes of share may carry different voting rights (McIntyre, 2018). It is a common practice for a newly listed company to issue two classes of shares. One class of shares, which carries limited voting rights, is offered to the general public. While another class is for, among others, company founders and executives, allowing them to maintain the majority control of the company by holding shares that provide more voting rights. Various classes of shares may also pay different amounts of dividends.
Deferred shares
Holders of deferred shares would not receive the dividend unless ordinary shareholders were paid a certain amount for that year. These shares are also called founder shares because they are often issued to the founders of the business that the company has been formed to purchase (French et al. 2018). They are eligible for big pay-outs once all the dividends were paid to the ordinary shareholders. Holders of these shares have full voting rights (CISI, 2020).
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Limited liability of the firm’s owners suggests that they are only liable for the amount of capital they invested in a firm. For example, if Mr. Greggs formed Sausage Roll Ltd by issuing ten shares with each worth £100, then he is effectively only liable for £1000 in the event of the liquidation. For private limited companies, the nominal value is usually £1 (although this can be set at any value). It is the minimum amount a member can, or agrees to pay, to take up a single share. A company can issue as many shares as it wants with the value that it wants to assign them. This is called share capital. For example:
1 share valued at £1; share capital equals £1
5 shares with each valued at £1; share capital equals £5
10 shares with each valued at £10; share capital equals £100
When ordinary shares of a public company are first issued, their nominal or par value is commonly valued at 25p per share (Pike et al., 2015). While private companies have no limit on share capital, the minimum capital required to incorporate plc is £50,000, one-quarter of which must be paid up.
According to Pike et al. (2015), share ownership lies at the heart of capitalism. By acquiring a portion of ownership in a company, an investor is entitled to receive dividends, participate in business through voting in general meetings, and have some degree of control in the company. Whether shares are traded or not, they are a fundamental concept in business and finance.
Bibliography
Chartered Institute for Securities & Investment (2020). Investment, Risk & Taxation: 11th edition. CISI: London
French, D. (2018). Company Law: 35th edition. Oxford University Press: Oxford
MacIntyre, E. (2018). Essentials of Business Law: 6th edition. Pearson: Harlow
Matthews, K., Giuliodori, M. and Mishkin, F.S. (2013). The Economics of Money, Banking and Financial Markets. [ebook] Pearson. Available at: https://www.perlego.com/book/811373/the-economics-of-money-banking-and-financial-markets-pdf
Pike, R., Neale, B. and Linsley, P. (2015). Corporate Finance and Investment: Decisions and Strategies 8th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/810751/corporate-finance-and-investment-decisions-and-strategies-pdf