Factors for the business to consider on equity financing
Issue costs
Issue costs vary considerably according to the method used to raise the new equity
Servicing costs
Equity holders expect relatively high returns in terms of capital appreciation and dividends. Dividends represent an explicit cost. The capital appreciation results from the
fact that profits not paid out as dividends still belong to the shareholders, even if they
have to wait until they sell their shares or the business is liquidated before they can
turn retained profit into cash. Thus, one way or another, the entire profits will eventually be paid out to shareholders.
Obligation to pay dividends
Dividend payment levels are a question of the discretion of directors and financial
managers. As we saw under ‘Servicing costs’ above, ultimately the shareholders will
receive their money, but they cannot directly force payment of a particular level of
dividend in a particular year.
Obligation to redeem the investment
There is no such obligation unless (or until) the business is liquidated. Because of this,
and to some extent because of the flexibility on dividend levels, finance provided by
ordinary shareholders does not normally impose a legally enforceable cash flow obligation on the business.
Tax deductibility of dividends
In contrast to the servicing of virtually all other types of finance, dividends are not
tax deductible in arriving at the business’s corporation tax liability. This tends to make
dividends more expensive than a similar gross equivalent loan interest rate.
Effect on control and freedom of action
Where new equity finance is raised other than from the existing shareholders in the
same proportions as their original investment, voting power will shift to some extent,
perhaps to a large extent, and possibly with it control of the business. This is not necessarily a feature of all increases in equity financing. In fact, the two most important
means of raising equity finance for most businesses, retained profits and rights issues
(each discussed below), generally avoid this problem.
Until recently, it was doubtful whether this shift in power was really of much concern to typical ordinary shareholders, since they seemed not to use their votes in any
case. The annual general meetings of most businesses were characterized by a distinct
absence of most of those entitled to be present and to vote. More recently, however,
the institutional investors have taken a much more active role as shareholders.
Sometimes this can mean applying pressure directly on boards of directors.
Level of return
The level of return on equity financing would be expected to be higher than the level
of return associated with ‘safe’ investments such as UK government securities. This
has historically been the case, with real returns from UK equities averaging around
6.5 per cent p.a. from 1900 to 2001 (Dimson, Marsh and Staunton 2002), contrasting
with an average real return from government securities of about 3 per cent p.a. over
the same period. Compared with other types of security, ordinary shares have on
average provided the best, though often an incomplete, hedge against inflation.
Equities provide an opportunity to make investments where returns are related
fairly directly to commercial success. Direct ownership of the assets of a business normally requires investors to spend time managing those assets. It normally also exposes
investors to unlimited liability. However, equities enable delegation of day-to-day
management to the directors and allow the shareholders to protect their other assets.
Riskiness of returns
Returns, in terms both of capital gains and of dividends, are not certain by any means.
Negative returns are very common over short periods, though, historically, aboveaverage positive returns in other periods compensate for these. A period of adverse
trading could, in theory, cause the value of a particular business’s ordinary shares
to fall to zero, losing the shareholder the entire amount invested in those shares.
Extensive losses of value of the shares of particular businesses are by no means rare.
For example, the shares of the bank Northern Rock plc fell from more than £12 a share
in January 2007 to less than £1 a share by January 2008.
Ease of liquidating the investment
Typically, when investors take up part of an issue of new equity of a business, they
have no particular thoughts of the business ever repaying that investment. However,
the average investor would be reluctant to take up equities unless it were clear that
there would be the opportunity to liquidate the investment in some other way. This is
where the secondary capital market comes in. It is clearly in the interest of the business to have its ordinary shares regularly traded on a recognised stock exchange so
that the facility to liquidate the investment exists.
Equities and personal tax
In the UK, dividends are taxed as income in the hands of the shareholder, at marginal
rates up to 40 per cent. Capital appreciation is subject to capital gains tax at rates similar to those applied to income.
Degree of control
Ordinary shares typically carry voting rights. This puts shareholders in a position,
perhaps acting together with other shareholders, to apply pressure to the business’s
senior management on any matter of concern.