NISM Series IIA: Chapter II — Characteristics of Equity Shares

1. Investors in Equity Shares

A company raises equity capital to meet its long-term funding requirements for expansion or continuing operations. This type of capital does not impose any liability on the company in terms of returns or repayment. The ownership rights of equity investors depend directly on the proportion of the issued capital they hold.

Categories of Equity Investors

A. Promoters

• Definition & Role: Promoters are the group of investors who set up the company and bring in the initial capital required to start the business.
• Risk Capital: The capital they contribute is the initial risk capital, which serves to protect the business from fluctuations in earnings and provides the base to leverage further capital.
• Control: Promoters usually retain majority shareholding in the company so that they can continue to control its affairs even after their stakes are diluted.

B. Institutional Investors

• Entities Included: These include Financial Institutions, Venture Capital Companies, Foreign Venture Capital Companies, Mutual Funds, Foreign Financial Institutions, Foreign Portfolio Investors, Qualified Foreign Investors (QFI), and banks.
• Professional Expertise: They are professional investors who possess the ability to evaluate business propositions, associated risks, and expected returns.
• Allotment Method: Companies often allot shares to these investors via private placements, which carry much lower regulatory requirements compared to public issues.
• Risk-Return Dynamics: Their risks and returns depend heavily on the stage of the business at which they bring in their capital.

C. Public Investors

• Composition: This category comprises retail investors, High Net Worth Individuals (HNIs), non-institutional investors, or institutional investors.
• Investment Focus: Retail investors and HNIs are primarily focused on the returns they can generate through capital appreciation and dividends, rather than seeking control or management of the company.
• Participation: Because their primary interest is financial return rather than corporate control, they hardly exercise their voting rights.

2. Features of Equity Share Capital

Ordinary equity capital has several distinct structural features:

• Ownership Rights: Issuing ordinary equity capital grants proportionate ownership rights to the shareholders. Investors are given voting rights, which allow them to vote on important decisions taken by the company.
• Perpetuity: Equity capital is for perpetuity. A company is not required to return the equity capital to the investor, and it does not redeem or repay the amount invested. Investors who want to exit must sell their shares in the secondary stock market to other buyers.
• Non-Guaranteed Returns: Investment in equity shares does not come with any guarantee of income or security. Returns are generated via dividends and capital appreciation, neither of which is guaranteed by the company or any other entity.
• Limited Liability: Shareholders' liability is limited to the extent of their investment; if creditors cannot recover their dues from the business, equity shareholders cannot be asked to pay up out of their personal assets.

3. Risks in Equity Investing

Equity investing carries unique risks due to its position in the capital structure:

• No Fixed Return: Dividends are not pre-defined in terms of percentage, timing, or payment dates. They are declared only if the company makes sufficient profits and the management deems it appropriate to distribute them.
• No Fixed Tenor: There is no maturity period or fixed tenor after which the money is returned by the issuer. Exit is entirely dependent on secondary market liquidity (selling shares to other investors on the stock exchange).
• No Collateral Security: Equity capital is completely unsecured. In the event of liquidation, the cash and assets of the company are applied first to settle the claims of lenders and creditors. The claims of equity shareholders always rank last in order of preference.

4. Dividends on Equity Shares

Dividends represent a share of the residual profits of a company distributed periodically to its shareholders.

Key Rules and Concepts

• Residual Claim: Equity shareholders are entitled to share only in the residual profits of the company after all other obligations are met.
• Grounded on Face Value: Dividends are always declared and calculated as a percentage of the face value (par value) of the shares, not the market price.
• Final vs. Interim Dividends:
  • Final Dividend: Declared at the end of the financial year.
  • Interim Dividend: Declared during the financial year.

Dividend Yield Relationship

The relationship between a share's price and its dividend yield is inverse.

\[\text{Dividend Yield Relationship: If share price moves up, the dividend yield comes down, and vice versa.}\]

• Formula Representation in Simple Line Format:
  • Dividend Yield = (Dividend Per Share / Share Price) * 100 (Note: Calculated as annual dividend divided by current market price to measure yield against market value.)

5. Preference Shares

Preference shares are hybrid instruments that combine elements of both debt and equity capital.

Core Features of Preference Shares

• No Fixed Maturity: Like equity, preference shares do not have a fixed maturity period.
• Fixed Dividends: They resemble debt instruments because they offer a pre-determined, fixed rate of dividend mentioned at the time of issue. However, this dividend is payable only if the company has sufficient profits.
• Preference Status: Preference shareholders have dual priority over ordinary equity shareholders:
  1. Dividend Priority: Preference dividends must be paid before any dividend is paid to ordinary shareholders.
  2. Winding Up Preference: In the event of liquidation/winding up of the company, preference shareholders have priority in the repayment of capital over ordinary equity shareholders.
• Voting Rights Limitation: Unlike ordinary shareholders, preference shareholders typically do not enjoy voting rights.
• Asset Claims: Unlike debt, preference shares do not have a right or charge over the assets of the company.

6. Rights Issue of Shares

A company can raise additional equity capital within its authorized capital limits. This is often done through a rights issue offered to existing shareholders.

Key Rights Issue Concepts

• Proportionate Offer: Rights shares are offered to existing investors in a proportion approved by the company's board of directors.
• Fractional Entitlements: When a rights proportion results in fractional shares for an investor, the handling of such fractional entitlements is left to the sole discretion of the Board of Directors.
• Impact on Share Capital: A rights issue increases the company's issued and paid-up capital. If an issue is a 1:1 rights issue, the capital doubles.
• Dilution Prevention: Because the shares are offered to existing investors in proportion to their current holdings, an investor's percentage ownership in the company remains exactly the same after the rights issue, provided they subscribe to their full entitlement.
• Impact of Non-Participation: If an investor chooses to forego (or sell) their rights, their proportionate holding in the company gets diluted by the fresh capital raised from other participating investors.

Summary Table: Equity vs. Preference Shares