What is equity finance?
Equity finance is money that a company raises by selling shares in the company to investors (the words "share", "stock" and "equity" are interchangeable). Investors take an equity stake in order to profit from dividends (receipt of a portion of company profits, usually on an annual basis) and a rise in the company's share price. Unlike debt finance, equity finance does not have to be repaid.
One of the main ways of raising equity finance is through an initial public offering (IPO). An IPO is the process by which a company, usually once its business has grown to a high value, sells its shares to the public for the first time by listing them on a stock exchange (for example, the London Stock Exchange (LSE) or the NASDAQ in New York). This article will focus on the IPO as means of explaining equity finance, but other ways of raising equity finance are available. For example, a company may make a private placement of shares - that is, offer its shares to a small number of investors selected in advance. Or a company may put more shares on the market after it has completed an IPO, which is known as a follow-on offering. If the company gives existing shareholders the right to purchase new shares before they are made available to the general public, the follow-on offering is known as a rights issue.
What kind of investors might purchase shares in a company?
- Angel investors: An individual or group of individuals who lend their own funds as equity to a business, usually in its early stages.
- Venture capitalists: Investment funds that offer capital provided by their own investors to developing businesses that they deem to have high potential, which are often in the technology sector.
- Private equity funds: Funds that make equity investments in companies that are not publicly listed.
- Pension funds and insurance companies: These are both important purchasers of listed shares.
How does a company benefit from an IPO?
- Injection of capital: The proceeds of an IPO could be used to expand into new markets, make corporate acquisitions or to reduce its "gearing" (that is, its proportion of debt to equity finance), as having a high gearing is generally regarded as a business risk.
- Valuation: Companies listed on a stock exchange tend to be worth more than companies which are not. Why? One reason is that investors are inclined to put a premium on the transparency that going public entails - for example, companies contemplating an IPO must issue a detailed prospectus and after the IPO must comply with heavy stock exchange reporting requirements. A second reason is that investors value the liquidity of shares in a public company - that is, they like the fact that they are able to buy and sell these shares easily.
- Prestige: Public companies tend to be viewed as more robust and stable than non-public companies. They also receive greater press coverage which has multiple valuable, though somewhat indirect, benefits such as helping with the recruitment and retention of high-quality employees. However, media attention can bring disadvantages as well as advantages.
- Access to further capital: Public companies are often able to raise money for expansion more easily and at better rates than private companies of a similar size. Also, since going public usually improves a company's gearing, it's usually able to borrow on more preferential terms in future for this reason too.
What are the drawbacks for a company of going public?
- Stock exchange/regulatory disclosure: Once a company makes an initial public offering, it must regularly disclose a large amount of information to stock exchanges and regulators. The aim of these disclosure requirements is to enable investors (existing or potential) to make informed decisions about whether to buy, sell or hold shares in the company. The administrative burden thus created can be heavy. In addition, disclosure requirements also mean that more information about the company must be placed in the public eye, meaning that information about its finances or strategy that it might rather keep private may well be available to competitors and to the media.
- IPO cost: IPOs involve a number of significant costs. These include: financial advisers' fees, lawyers and accountants' fees, public relations fees and the costs of keeping up to date with reporting and auditing requirements.
- Less control: Prior to going public, the managers of the company are also usually its owners. They therefore have the freedom to make the corporate decisions that they deem necessary. However, once the company goes public, the managers are no longer the sole owners. Instead they become "agents" of the company's shareholders - managers of public companies are required by law to act on behalf of, and in the best interests of, the shareholders - and therefore have less control.
- Dealing with investor expectations: Shareholders in public companies generally judge its management's performance in terms of profits and share price. The focus on these criteria puts significant pressure on the directors to increase profits each quarter and to meet market expectations. There are potential risks to such pressures - they can lead directors to prioritise short-term goals at the expense of more sensible long-term aims.
What steps does a typical IPO process involve?
In order for a company to execute an IPO, it needs to deal with the following five areas:
- Corporate matters: The issuing company needs to get its internal financial records and other official documentation in order. Once these are in place, it must also grapple with issues such as the timetable for the transaction and the composition of the board of directors, if it is to be changed following the IPO.
- Listing choices: Once the issuer has its house in order, it needs to decide how to answer some key questions. Which exchange would maximize company valuation and liquidity? Should the company list on just the local exchange, or more than one - for example, if other exchanges can offer a large number of potential purchasers of the shares?
- Regulation and documentation: A large amount of documentation must be provided to potential investors and regulators before the issue can proceed.
- Marketing, pricing and allocation: The banks advising the issuer mobilise their research, sales and syndication teams. These teams will advise on the marketing of the shares, the price at which they should be sold and to which initial buyers (the "syndicate").
- Aftermarket: The "aftermarket" is the term given to the period immediately after the issuer's shares have been priced and listed - that is, made available on the exchange for sale. This period is important because if a company's immediate performance is weak, then it may prove difficult to sell these shares on the stock exchange and impossible to raise further equity finance.