Companies issue different types of shares either to their existing shareholders or to the general public periodically to raise capital (money) for business purposes.
Companies often undertake a detailed cost-benefit analysis before issuing new shares. New shares are generally issued in two ways-rights issues and public issues.
This article shall succinctly discuss the different ways of issuance of new shares and the risks and advantages associated with each of them.
Public Issue of Shares
In the ‘Public Issue’ of shares, companies invite the general public to purchase the new shares at a price determined first by the issuing company and then influenced subsequently by market forces depending on whether one purchases them in the primary or secondary market.
The public issue of shares is defined u/s.2(rr) of ICDR and is governed by the relevant provisions of the Companies Act 2013 and SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations).
Broadly speaking, a company should be eligible to make a public offer u/s 102 ICDR which provides that an issuer shall not be eligible to make a further public offer if-
- the issuer, any of its promoters, promoter group or directors, selling shareholders are debarred from accessing the capital market by the Board;
- any of the promoters or directors of the issuer is a promoter or director of any other company which is debarred from accessing the capital market by the Board;
- the issuer or any of its promoters or directors is a wilful defaulter ;
- any of its promoters or directors is a fugitive economic offender.
The explanation attached to the provision provides that the restrictions under (a) and (b) above shall not apply to the persons or entities who have been debarred in the past by the Board (SEBI) and the period of debarment is already over as on the date of filing of the draft offer document with the Board.
In addition, a company going for the public issue of shares should also fulfill the General conditions mentioned u/s 104 and 105 ICDR for such issue of shares. S.104 provides that an issuer making a further public offer shall ensure that –
- it has made an application to one or more stock exchanges to seek an in-principle approval for listing of its specified securities on such stock exchanges and has chosen one of them as the designated stock exchange, in terms of Schedule XIX;
- it has entered into an agreement with a depository for dematerialization of specified securities already issued and proposed to be issued;
- all its existing partly paid-up equity shares have either been fully paid-up or have been forfeited;
- it has made firm arrangements of finance through verifiable means towards seventy-five percent. of the stated means of finance for the specific project proposed to be funded from the issue proceeds, excluding the amount to be raised through the proposed public issue or through existing identifiable internal accruals.
An issuer not satisfying the condition stipulated in sub-regulation (1) of Section 103 ICDR is also allowed to make a further public offer but only if the issue is made through the book-building process (defined u/s 2(g) of ICDR) by allotting a certain percentage of the issue to the Qualified Institutional Buyers.
Risks associated with the Public Issue
There are certain risks that are common to public offering due to the volatilities of the securities/capital market.
Needless to say, market conditions are unpredictable and the share prices fluctuate with time and situation due to various unknown and unexpected factors like economic slowdown, increment or decrement in companies’ profits, restructuring, business acquisitions, political instability, etc.
The ongoing covid-19 Pandemic is a classic example of businesses suffering due to disease and epidemics.
The risks include both absolute and variable risks. One example of absolute risk is the possibility of the company going bankrupt and out of business. Forced nationalization or takeover by the government is another risk.
Likewise, when the company faces certain market risks, its promotors also get affected in the same vein.
After all, it is they who control the affairs of the company, directly or indirectly whether as a shareholder, director, or otherwise; and in accordance with whose advice, directions, or instructions the board of directors of the issuer is accustomed to act.
The Promoter also holds at least 20% of the post-issue capital of the company (S.14 ICDR), so if anything goes wrong, he also gets affected. Other risks may include rating risks, detection risks, legislative risks, and inflationary risks, etc.
Notwithstanding the above-mentioned risks, the public issue has some advantages as well compared to the rights issue-
- It has the advantages of Listing on stock exchanges and consequently the advantage of trading
- It has an advantage of liquidity to the company and investor.
- There is no need for buyback as shareholders keep buying and selling shares.
- The probability of market manipulation becomes less due to increased scrutiny by government regulatory authorities like SEBI, etc.
Rights Issue to existing shareholders
In the ‘Rights offering’ or ‘Rights Issue’ of shares, only the existing shareholders of the company have the right to purchase the new shares issued by the company.
According to Adam Hayes, in such offerings, “companies grant shareholders the right, but not the obligation, to buy new shares at a discount to the current trading price”.
Rights issues can be of different types like direct rights offerings and insured or standby rights offerings.
In the former, no third party known as a backstop purchaser can purchase the non-subscribed shares but in the latter, third parties can purchase the remaining shares left out due to the non-subscription by the existing shareholders.
This unique arrangement also pre-empts the scenario of the undercapitalization of shares.
Alternatively, companies can also take the help of underwriters who guarantee the amount to be raised by the company. Underwriters are stabilizing agents (basically merchant bankers) who borrow extra shares for stabilizing purposes.
Another scenario known as the oversubscription privilege allows investors to buy some extra shares compared to that which was initially offered under the basic subscription.
It depends on the availability of extra shares. The left-over shares are filled on a pro-rata basis.
Further, a Company may issue additional shares to its existing shareholders by way of Bonus or Rights Issue (defined u/s 2(ss) ICDR).
In the case of the rights issue, the shares are issued to the existing shareholders of the company as on a particular date, known as the record date.
They are offered in a ratio corresponding to the number of shares or held by the shareholders as on the record date.
Also relevant here is Section 62(1) of the Companies Act, 2013 which provides that if the Company decides to issue fresh shares, it should first be offered to existing shareholders in proportion to their shareholding on a particular record date decided by the issuer.
Though the existing shareholders are given preference in the rights issues, they, can, however, refuse to purchase such shares because, in rights issues, they only have a right to purchase the new shares and not an obligation.
Chapter III of ICDR deals with the rights issue. Sections 60, 61, and 62 provide the eligibility conditions which include-
- It should be not debarred by the SEBI (s.62)
- It has made an application to one or more stock exchanges to seek an in-principle approval for listing of its specified securities on such stock exchanges and has chosen one of them as the designated stock exchange, in terms of Schedule XIX.
- All its existing partly paid-up equity shares have either been fully paid-up or have been forfeited;
- It has made firm arrangements of finance through verifiable means towards 75% of the stated means of finance for the specific project proposed to be funded from issue proceeds, excluding the amount to be raised through the proposed rights issue or through existing identifiable internal accruals.
Rights issues are also sometimes exempt from taxation u/s 65(2)(vii).
Risks associated with the Rights Issue
There are various risks and disadvantages associated with rights issues be they separate or simultaneous.
If the company’s growth trajectory is on a declining curve or if the company is facing some kind of slowdown, existing shareholders might not be interested in buying more shares from such a company.
The capital market may take it as a sign of the company not being profitable or viable for further business engagements. All this may end up negatively affecting the ratings and reputations of the company.
This in turn may also entice the existing shareholders to sell their shares and thus reducing the price per share. Consequently, a floodgate of risks and bad luck for the company opens. In-toto this scenario can badly affect the market value of the concerned company.
Conclusion
Rights and Public issues of shares are two prominent ways in which companies issue shares to raise capital to fulfill their business goals.
Relevant provisions of the Companies Act 2013 and SEBI (ICDR) Regulations provide for the eligibility criteria for both rights and public issues some of which have been discussed succinctly in the foregoing article.
Both rights and public issue have their distinct advantages and disadvantages.
Some of the advantages of a public issue of share include the benefit of getting listed on recognized stock exchanges and further trading therein, enhanced liquidity, less market manipulation due to increased regulation by government regulatory authorities like SEBI, etc.
However, companies decide to go for public and right issues after conducting a detailed and comprehensive cost-benefit analysis taking into account the prevailing market situation, government policies, their financial health, and other surrounding circumstances.
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