158 5 Equity and Shareholders’ Capital
ers: “... the SPE may, on the basis of a proposal of the management body, make a
distribution to shareholders provided that, after the distribution, the assets of the
SPE fully cover its liabilities. The SPE may not distribute those reserves that may
not be distributed under its articles of association.” (d) The articles of association
can also require a solvency certificate before a distribution is made.
Third, the proposed SPE Regulation contains rules designed to prevent circum-
vention. Such rules include rules on the acquisition of the SPE’s own shares and
on the redemption of shares.
5.5 Strategic Choices
Equity and shareholders’ capital raise fundamental questions of corporate strategy.
The firm must answer four important questions: (1) What should be the mix of the
firm’s equity and debt? (2) How should the firm’s equity be allocated between dif-
ferent classes of equity instruments? How much shareholders’ capital should the
company have? (3) What should be the shareholder base of the company? (4)
Should the company’s shares be privately-owned or traded on a regulated market?
Reasons to use equity. The use of equity brings many benefits but can have
some drawbacks.
From a financial perspective, the core benefits are as follows: (a) Increasing
equity reduces the risk of corporate failure in an economic downturn. (b) Increas-
ing equity can improve the credit rating of the firm and decrease the cost of debt
capital. (c) Issuing shares can generally give access to shareholders’ ancillary ser-
vices. (d) Issuing shares can sometimes enable the firm to purchase ancillary ser-
vices and assets that it otherwise would not be able to purchase. For example: an
entrepreneur may only want to sell his business to the firm if he becomes a large
shareholder in the firm; a certain manager might only want to work for the firm if
he is given shares and option rights; and an important supplier of branded goods
might only want to export its goods to importers that it owns or controls.
The use of equity can nevertheless have some drawbacks: (a) Decreasing gear-
ing can reduce return on equity. (b) If the company has a very low debt-to-equity
ratio, debt does not force its managers to be effective. (c) Shareholders’ contribu-
tions can be expensive, because shareholders expect a higher return or more bene-
fits as a reward for higher risk. (d) Share capital is not as flexible as debt capital,
because many relevant company law rules are mandatory. (e) It is more difficult
for managers to decide on share capital transactions because many decisions on
share capital must be decided on by shareholders in general meeting under manda-
tory company law rules. (f) Issuing more shares can dilute the holdings of existing
shareholders and make shareholders object to new share issues.
Reasons for being privately-owned. In theory, a company whose shares are
traded on a regulated market can have easier access to equity capital. In practice,
however, almost all businesses in the world are privately-owned and only a small
proportion of firms have gone public. The most important benefits of being
privately-owned include flexibility and confidentiality.