CHAPTER 13 Financing the business 54913.7 Equity finance
LEARNING OBJECTIVE 13.7 Explain equity finance instruments and their roles.
Owners may at times wish to expand their entities or liquidate some or all of their ownership rights.
They achieve this by selling ownership rights to other investors. The media by which ownership rights
are packaged, sold (and bought) and transferred are ordinary shares and preference shares. Ordinary
shares are by far the more common of the two. All companies issue ordinary shares; some, but not all,
companies issue preference shares.
Ordinary shares
As explained in chapter 2, ordinary shares are the main type of share by which companies divide and
sell ownership rights to investors. Ordinary shares have an initial issue price but, after that time, their
price is set by the secondary market.
In the case of private companies, ownership is normally still divided up into shares, but often there
may be as few as five or 10 shares only in each company. The value of each share is usually very diffi-
cult to ascertain. Additionally, as these are often family-owned companies, there may be a family tra-
dition or unwritten principle that the shares are not sold outside the family.
Ordinary shares have no fixed maturity date, unlike most forms of debt. The shares continue to exist
so long as the entity exists. However, individual shares may undergo transformations such as share con-
solidations or share splits. The payments attaching to shares are dividends, the amounts of which are not
guaranteed. Directors decide upon and declare dividends, normally twice a year, after the profitability of
the company for the relevant period has been calculated. However, if there are no or insufficient profits
after interest and taxes have been paid, dividends may not be paid and ordinary shareholders do not have
any cumulative rights. Dividends may also not be paid if there is insufficient cash in the entity.
Ordinary shares rank last in the event of the winding-up of the company. The claims of people holding debt
(the senior-ranked debt being paid first) are settled first, followed by the claims of preference shareholders.
In most insolvencies, ordinary shareholders receive no repayment of their invested funds at all, because the
pool of cash accumulated through the liquidation of assets is insufficient to pay out in full all those who rank
above them. This chance increases the risk associated with ordinary shares. The collapse of Borders Group
is a good example of a situation where the remaining assets of the group were put into a liquidating trust for
payment of taxes and professional fees. The ordinary shareholders were left with nothing.
One of the major attractions of ordinary shares is their limited liability. If shareholders were held
responsible and liable for all the actions of the employees of the companies in which they had invested
funds, most reasonably risk-averse people would not invest in shares, but would merely invest in debt
securities. The securities exchanges as we know them today would not exist! Thus, limited liability for
shareholders enables companies to raise equity capital where otherwise they would be unable to do so.
Shareholders are liable only to the extent of their subscribed capital in the case of initial shareholders,
and to the extent of the price paid for shares in the case of later shareholders.
Preference shares
Preference shares are a hybrid form of capital, just as the convertible notes discussed above are a mix
of debt and equity. Preference shares tend to lean more towards equity than debt. Issuers are able to
attach different sets of rights to their issues of preference shares, so the debt and equity characteristics
vary between securities. Preference shares are legally regarded to be equity, even if their economic sub-
stance for accounting purposes deems them to be debt, and preference dividends are regarded as a distri-
bution of profits, not a tax-deductible expense.
Preference shares rank ahead of ordinary shares for repayment in the event of the winding up of the
company. Additionally, the payment of preference share dividends ranks ahead of the payment of ordi-
nary dividends. Moreover, preference shares usually have a fixed dividend (e.g. 10 per cent of issue