Equity Finance

1 Introduction

This chapter evaluates the ways an entity raises equity finance, and what each of them means for the people running the entity and for the people who already own it.

There are two distinct situations, and the syllabus asks about both. An unquoted entity that wants access to the public equity markets has first to get there — that is a flotation, and section 2 deals with the methods and their consequences. An entity that is already quoted has a wider and cheaper set of choices, of which the rights issue is the most important and the most examinable; sections 3 and 4 deal with those, including the calculation of the theoretical ex-rights price (TERP) and the yield-adjusted TERP.

2 Flotation

A flotation, or initial public offering, is the process by which an entity's shares are admitted to trading on a stock exchange for the first time.

2.1 Why float, and why not

2.2 The methods of flotation

Only the first three raise money. An introduction creates a market in shares that already exist; it raises nothing. That single distinction answers most examination questions on choosing between the methods.

2.3 The process and the parties

• Sponsor or nominated adviser — guides the entity through the exchange's rules and confirms to the exchange that it is suitable to be listed.

• Broker or bookrunner — markets the issue to investors and, on a book-built offer, collects the indications of demand from which the price is set.

• Reporting accountants — report on the historical financial record and on whether the entity has sufficient working capital for a stated period after the flotation.

• Lawyers — verify the statements made in the offering document (in many regimes a prospectus), on which the directors take personal responsibility and on which investors are entitled to rely.

• Underwriters — agree, for a commission, to take up any shares not taken by investors. Underwriting converts an uncertain amount of money into a certain one; the commission is the price of that certainty and is payable whether or not the underwriters are called on.

Exchanges also impose entry requirements — typically a minimum market capitalisation, an audited trading record of some years, a minimum proportion of the shares in public hands (the free float), and continuing disclosure obligations. The specific thresholds differ from exchange to exchange and from market tier to market tier, and are not examinable; that the requirements exist, and that they are lighter on a growth market than on a main market, is.

2.4 The implications for management

• control is diluted, and permanently: decisions have to be justified to outside shareholders, and the entity becomes vulnerable to a takeover it does not want;

• management is measured continuously by a share price, which creates pressure towards decisions that flatter the near term;

• the continuing obligations are real work — reporting timetables, disclosure of price-sensitive information, governance codes, and restrictions on when directors may deal in their own shares;

• against that, management gains a currency for acquisitions, a means of incentivising staff with shares that have a value, and access to equity on a scale a private entity cannot reach.

2.5 The implications for shareholders

• existing shareholders get what they usually floated for — a market, a price, and a route to sell, though lock-in agreements normally prevent the founders selling for a period after admission;

• their percentage holding falls if new shares are issued, and their influence falls further than the percentage suggests once the register is widened;

• if the issue is underpriced, value moves from the existing shareholders to the new ones. That is not a small point and it is examined numerically — see Example 2;

• new shareholders acquire a liquid, objectively valued holding with continuing information rights, and the ability to sell at any time, which is what they are paying the flotation premium for.

3 Further issues by an entity that is already quoted

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Once an entity is listed, the following methods are available for issuing new shares.

3.1 Public issue (offer for subscription)

A sale direct to the general public. The shares are advertised at a fixed offer price and the public are invited to buy them. In practice it is difficult to set a fixed offer price that satisfies both the existing and the new shareholders, and Example 2 shows why: the price determines how the value created by whatever the money is spent on is divided between them.

3.2 Public offer for sale by tender

A sale direct to the general public, but with no fixed price: the public are invited to bid, and a striking price is set at the level that clears the issue. It transfers the pricing problem to the market, at the cost of deterring investors who do not want to name a price.

3.3 Placing

A sponsor, usually an investment bank, arranges for its institutional clients to buy the shares. It is quick and cheap. Exchanges commonly require a proportion of a placing to be made available more widely, so that the free float is maintained.

3.4 Rights issue

An offer to existing shareholders to buy new shares in proportion to their existing shareholdings. It is dealt with in section 4, because it is the method that generates the calculations.

4 Rights issues

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A rights issue is an offer to existing shareholders to subscribe for new shares in proportion to their existing holdings — a 1-for-4 issue offers one new share for every four held.

The shares are offered at a price below the current market value (the cum-rights price). The discount is not a gift; it is protection. The offer stays open for some weeks, and if the market price fell below the issue price during that period nobody would take up the offer and the issue would fail. A deep discount makes that outcome very unlikely, which is why a company that wants certainty of proceeds discounts heavily rather than underwriting heavily.

The discount does not by itself make shareholders better or worse off. Because more shares now exist and they have been sold below the market price, the value of every share in issue falls to a weighted average of the old price and the issue price. That weighted average is the theoretical ex-rights price.

4.1 The theoretical ex-rights price

TERP = 1 ÷ (N + 1) × [(N × cum-rights price) + issue price]

where N is the number of existing shares needed to obtain one new share — 4 in a 1-for-4 issue, 3 in a 1-for-3. It is easier, and less error-prone, to lay the same calculation out as a small table, which is what the answers below do.

4.2 The effect on shareholder wealth

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A shareholder in a rights issue has three choices: take up the rights, sell the rights, or do nothing. The first two leave wealth unchanged. The third destroys it, by exactly the value of the rights that were thrown away.

4.3 The yield-adjusted theoretical ex-rights price

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The ordinary TERP assumes the money raised earns exactly what the entity's existing funds earn, so that the new shares are worth the same as the old ones. Where the money is going into something expected to earn a different return, the new shares are not equivalent to the old ones and the calculation is weighted to reflect it:

Yield-adjusted TERP = 1 ÷ (N + 1) × [(N × cum-rights price) + (issue price × Y_new ÷ Y_old)]

5 Unquoted entities

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An unquoted entity that does not want to float, or is not yet in a position to, still has ways of raising equity:

• A rights issue to the existing shareholders — always available, and it needs no market. What it needs is shareholders with money.

• A private placing — new shares sold directly to a small number of investors, negotiated one to one.

• Venture capital or private equity — a specialist investor takes a substantial minority or majority stake, usually with board representation, a defined exit horizon and rights that a listed shareholder would never have. Private equity as an acquirer of businesses is a different subject and belongs to the valuation chapters later in this text.

• A reverse takeover — the unquoted entity acquires a listed one, or is acquired by it in exchange for shares, with the result that its owners control a listed vehicle. It is a route to a listing rather than a source of finance in itself.

The obstacle to a listing is size. Most markets have a tiered structure — a main market with the fullest requirements and the largest entities, and one or more growth markets with lighter entry and continuing requirements, aimed at smaller entities. The names differ from country to country. What matters is the pattern: lighter requirements on the growth market, and in exchange less liquidity, a narrower investor base and a lower profile.

6 Bonus issues and stock splits

Neither of these raises any money. Both increase the number of shares in issue and reduce the price of each, which can make the shares more marketable — a share trading at $60 is a less convenient unit than one trading at $6.

7 Scrip dividends

A scrip dividend offers shareholders new shares instead of a cash dividend, leaving the choice to each shareholder. For the entity it is a way of retaining cash while still making a distribution, and the new shares are, in effect, issued for the cash that would otherwise have gone out.

A scrip dividend is a dividend decision rather than a share-issue decision, and it is dealt with with the rest of dividend policy in chapter 7.

8 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.