Types of Equity

Common stock, as it is known in the United States, or ordinary shares, according to British terminology, is the most important form of equity investment. An owner of common stock is part owner of the enterprise and is entitled to vote on certain important matters, including the selection of directors. Common stock holders benefit most from improvement in the firm's business prospects. But they have a claim on the firm's income and assets only after all creditors and all preferred stock holders receive payment. Some firms have more than one class of common stock, in which case the stock of one class may be entitled to greater voting rights, or to larger dividends, than stock of another class. This is often the case with family owned firms which sell stock to the public in a way that enables the family to maintain control through its ownership of stock with superior voting rights.

Preferred stock

Also called preference shares, preferred stock is more akin to bonds than to common stock. Like bonds, preferred stock offers specified payments on specified dates. Preferred stock appeals to issuers because the dividend remains constant for as long as the stock is outstanding, which may be in perpetuity. Some investors favor preferred stock over bonds because the periodic payments are formally considered dividends rather than interest payments, and may therefore offer tax advantages. The issuer is obliged to pay dividends to preferred stock holders before paying dividends to common shareholders. if the preferred stock is cumulative, unpaid dividends may accrue until preferred stock holders have received full payment. In the case of non cumulative preferred stock, preferred stock holders may be able to impose significant restrictions on the firm in the event of a missed dividend.

Convertible preferred stock

This may be converted into common stock under certain conditions, usually at a predetermined price or within a predetermined time period. Conversion is always at the owner's option and cannot be required by the issuer. Convertible preferred stock is similar to convertible bonds.

Warrants

Warrants offer the holder the opportunity to purchase a firm's common stock during a specified time period in future, at a predetermined price, known as the exercise price or strike price. The tangible value of a warrant is the market price of the stock less the strike price. If the tangible value when the warrants are exercisable is zero or less the warrants have no value, as the stock can be acquired more cheaply in the open market. A firm may sell warrants directly, but more often they are incorporated into other securities, such as preferred stock or bonds. Warrants are created and sold by the firm that issues the underlying stock. In a rights offering, warrants are allotted to existing stock holders in proportion to their current holdings. If all shareholders subscribe to the offering the firm's total capital will increase, but each stock holder's proportionate ownership will not change. The stock holder is free not to subscribe to the offering or to pass the rights to others. In the UK a stock holder chooses not to subscribe by filing a letter of renunciation with the issuer.

Issuing shares

Few businesses begin with freely traded shares. Most are initially owned by an individual, a small group of investors (such as partners or venture capitalists) or an established firm which has created a new subsidiary. In most countries, a firm may not sell shares to the public until it has been in operation for a specified period. Some countries bar firms from selling shares until their business is profitable, a requirement that can make it difficult for young firms to raise capital.

Flotation

Flotation, also known as an initial public offering (ipo), is the process by which a firm sells its shares to the public. This may occur for a number of reasons. The firm may require additional capital to take advantage of new opportunities. Some of the firm's original investors may want it to buy them out so they can put their money to work elsewhere. The firm may also wish to use shares to compensate employees, and a public share listing makes this easier as the value of the shares is freely established in the market place. The flotation need not involve all or even the majority of the firm's shares. The value of Ipos in the UK, although much smaller, has been less volatile.

Some of the biggest flotations in recent years have involved the privatization of government owned enterprises, such as Deutsche Telekom in Germany and YPF, a petroleum company, in Argentina. Such large firms are often floated in a series of share issues rather than all at once, because of uncertainty about demand for the shares. According to the OECD, privatizations raised nearly $600 billion between 1996 and 2000, much of which was financed by issuance of shares. Another source of large flotations is the spin off of parts of existing firms. In such a case, the parent firm bundles certain assets, debt obligations and businesses into the new entity, which initially has the same shareholders as the parent. Among the largest spin offs in recent years have been Lucent Technologies, formerly part Of AT&T, and Delphi, the component manufacturing unit of General Motors Corp. A third source of large flotations has been decisions by the managers of established companies with privately traded shares to allow limited public ownership, as in the case of ups, an American package delivery company.

Private offering

Rather than selling its shares to the public, a firm may raise equity through a private offering. only sophisticated investors, such as money management firms and wealthy individuals, are normally allowed to purchase shares in a private offering, as disclosures about the risks involved are fewer than in a public offering. Shares purchased in a private offering are common equity and are therefore entitled to vote on corporate matters and to receive a dividend, but they usually cannot be resold in the public markets for a specified period of time.

Secondary offering

A secondary offering occurs when a firm whose shares are already traded publicly sells additional shares to the public called a follow on offering in the UK or when one or more investors holding a large proportion of a firm's shares offers those shares for sale to the public. Firms that already have publicly traded shares may float additional shares to increase their total capital. If this leaves existing shareholders owning smaller proportions of the firm than they owned previously, it is said to dilute their holdings. if the secondary offering involves shares owned by investors, the proceeds of a secondary offering go to the investors whose shares are sold, not to the issuer.

The flotation process

Before issuing shares to the public, a firm must engage accountants to prepare several years of financial statements according to the Generally Accepted Accounting Principles, Or GAAP, of the country where it wishes to issue. In many countries, the offering must be registered with the securities regulator before it can be marketed to the public. The regulator does not judge whether the shares represent a sound investment, but only whether the firm has complied with the legal requirements for securities issuance. The firm incorporates the mandatory financial reports into a document known as the listing particulars or prospectus, which is intended to provide prospective investors with detailed information about the firm's past performance and future prospects. in the United States, a prospectus circulated before completion of the registration period is called a red herring, as its front page bears a red border to highlight the fact that the regulator has not yet approved the issuance of the shares.