Equity

Equity, quite simply, means ownership. Equities, therefore, are shares that represent part ownership of a business enterprise. The idea of share ownership goes back to medieval times. It became widespread during the Renaissance, when groups of merchants joined to finance. trading expeditions and early bankers took part ownership of businesses to ensure repayment of loans. These early shareholder owned enterprises, however, were usually temporary ventures established for a limited purpose, such as financing a single voyage by a ship, and were dissolved once their purpose was accomplished.

The first shareholder owned business may have been the Dutch East India Company, which was founded by Dutch merchants in 1602 and issued negotiable share certificates that were readily traded in Amsterdam until the company failed almost two centuries later. By the late 17th century, traders in London coffee houses earned their living dealing in the shares of joint stock companies. But it was not until the industrial revolution made it necessary to raise large amounts of capital to build factories and canals that share trading become widespread. Today, the capitalization of the world's stock markets approaches $350 trillion.

Raising capital

Raising capital remains the main function of equity markets. But the equity markets are not the only way for firms to raise capital. Before turning to the markets to obtain financing, firms undertake a detailed analysis of alternative methods of meeting their requirements.

Loans

Loans are the main type of financing available to firms that have not issued securities. Lenders such as banks are accustomed to analyzing the business plans and financial condition of small firms, and often lend to companies that would have difficulty raising funds in the financial markets. Bank loans, however, are expensive, and banks can lend only a limited amount to a single borrower. Firms which are able to do so often prefer to diversify their borrowing by selling bonds, securities that entitle the holder to payment of interest and repayment of principal at predetermined times. Bonds have the disadvantage of imposing a fixed repayment obligation, which may be difficult to meet if the firm's revenue is weak. Some firms can meet part of their financing needs by securitization, the sale of securities backed by assets that will generate income in the future. But some firms lack the sorts of assets that are readily packaged into securities, and others may be too small to make securitization worthwhile. In many countries, markets for securitized assets have yet to develop.

Equity

Equity, unlike all of these other forms of financing, represents the owners' investment in the firm. Bankers and bond investors will be more generous if the firm has substantial equity capital, because this ensures that the borrowers, the firm's owners, have put their own money at risk. The disadvantages of issuing equity are that the firm's profit must be divided among the shareholders and that managers and directors must give primary consideration to investors' interest in improved short term earnings rather than pursuing strategies that show less immediate promise.