JARGON BUSTER: RAISING CAPITAL
Roy Davidson, 15 January 2020
If you have owned shares directly in a company, you may have been offered a chance to purchase additional shares at a discounted price. This is known as a capital raise. In this jargon buster we explain why companies may look to raise additional funds from shareholders, and the different ways they go about it.
Why do companies raise capital?
By conducting a capital raise, also known as an equity raise, a company is basically looking to get additional funds from its shareholders. This could be for a variety of reasons including to finance future growth plans, fund an acquisition, or lower debt levels.
For example, an early stage technology company that does not currently make a profit may need to ask shareholders to dip into their pockets to finance its growth aspirations. Shareholders would be willing to provide the company with additional funds with the expectation that in the future, once it has reached critical mass, it will move to profitability and be able to pay dividends to shareholders.
How do companies go about raising capital?
There are a number of ways a company can go about raising additional funds from shareholders. While it can appear complicated, all of these essentially work on the same premise; offering shareholders additional shares in the company at a discount to the current market price.
There are four common ways that you will see a company raise capital:
1. Arguably the most common way is through a rights issue. This involves a company offering shareholders the right to purchase additional shares based on how many shares they currently own. For example, if a company announces a one for seven rights issue, this means that for every seven shares you own, you are entitled to purchase one additional share at the discounted price. Shareholders that do not take up their rights usually have the ability to sell them so that they receive some value from their rights. The key advantage of a rights issue is that, as it is based on current holdings, it is equitable to all shareholders.
2. A share purchase plan offers shareholders the ability to purchase new shares up to a maximum dollar amount. Unlike a rights issue, this is not based on the number of shares owned, meaning someone with just one share in the company can buy as much as someone who owns several hundred thousand shares. This means it can be advantageous if you are a small shareholder, and potentially disadvantageous if you are a larger one. Additionally, there is usually no ability for shareholders to sell any rights, meaning if you don’t participate in the share purchase plan you won’t receive any compensation for having your percentage shareholding in the company diluted.
3. A placement involves a company issuing new shares to a small number of pre-selected investors (usually institutions like fund managers or super funds). These investors may or may not be existing shareholders. The advantage to the company making the placement is that it can be done quickly and at a lower cost. However, it excludes a significant number of shareholders from being able to participate, thereby diluting their percentage shareholding. For this reason, placements are often done in conjunction with share purchase plans to enable smaller shareholders to participate.
4. A company may also offer a dividend reinvestment plan (DRP). This gives shareholders the option of receiving shares in a company in lieu of a dividend.
Sometimes companies want to return capital to shareholders
Having too much debt can be problematic for a company. However, it can also be less than ideal to have too little debt. This is because it is cheaper for companies to raise funds from debt as opposed to from equity (i.e. shareholders). Having more debt can therefore boost returns for shareholders.
As a result, companies sometimes want to return capital to shareholders, thereby raising their debt levels (known as increasing their ‘gearing’ or ‘leverage’). The most common ways this is done is through special dividends or a share buyback programme.
If returning capital by way of a dividend, a company will often call this a special dividend to indicate that it is one-off in nature and shouldn’t be expected on a continuing basis.
A share buyback involves a company actively purchasing its own shares and then cancelling them. This has the effect of lowering the number of shares on issue, making the remaining shares more valuable.
This is an excerpt of an article first published in the December 2019 edition of News & Views. Craigs Investment Partners clients can view the latest edition of News & Views, which includes the full version of this article, by logging in to Client Portal.