Equity Shares : Merits and Demerits

What are Equity Shares?

A company’s most important source of long-term capital is equity shares. Because equity shares represent a company’s ownership, the capital raised through the issuance of such shares is known as ownership capital or owner’s funds. A company must have equity share capital in order to be established. Equity shareholders are paid on the basis of the company’s earnings rather than a fixed dividend. They are known as residual owners since they receive what remains after all other claims on the company’s income and assets have been satisfied. They gain from the reward while also bearing the risk of ownership. Their liability is limited to the amount of capital they invested in the company.

Geeky Takeaways:

• When an investor holds equity shares in a company, they become partial owners of that company.
• Equity shareholders may receive a share of the company’s profits in the form of dividends.
• Equity shares are considered riskier compared to other financial instruments, such as bonds.

Features of Equity Shares

1. Primary Risk Bearers: The equity shareholders of a company are its primary risk bearers. It means that if the company faces a loss, then its shareholders will have to bear the loss. Also, before paying the equity shareholders their due payment, it is first given to the company’s creditors.

2. Basis for Loans: A company can raise loans based on its equity share capital. The amount of equity share capital adds up to the credibility of the company and thus increases the confidence of the creditors.

3. Claim over Residual Income: The equity shareholders of a company have a claim over its leftover income only. It means that, after satisfying all the claims of every creditor, outsider, and preference shareholder, if the company is still left with income, the equity shareholders can claim that money.

4. Higher Profit: The rate of interest of debenture holders and the rate of dividend for preference shareholders are fixed; however, there is no fixed rate for equity shareholders. Therefore, in the case of profit, the debenture holders and preference shareholders will get the fixed income only; however, the equity shareholders will enjoy a higher profit.

5. Control: The equity shareholders have control over the activities of a company. They have voting rights and thus can case vote for the selection of the Board of Directors. The Board of Directors are those who control and manage the company’s affairs.

6. Pre-emptive Rights: The provisions of Companies Act gives Pre-emptive rights to the shareholders. This right states that, whenever a company plans to issue new equity shares, first of all, it must offer the shares to its existing shareholders. If they refuse to buy the new shares, then only the company shall offer the shares to the general public. By doing this, the right protects the equity shareholder’s controlling rights.

7. Permanent Capital: The equity shareholders of a company provide it with permanent funds. The company does not commit to return the money or pay dividends at a fixed rate.

Merits of Equity Shares

1. Ideal for Adventurous Investors: Equity shares are appropriate for investors who are willing to take on risk in exchange for higher returns.

2. No Obligation to give Dividends: The payment of dividends to equity shareholders is optional. As a result, the company bears no burden in this regard.

3. Source of Fixed Capital: Equity capital is permanent capital because it is repaid only when a company is liquidated. It provides a buffer for creditors in the event of a company’s insolvency because it is listed last on the list of claims.

4. Provides Credit Standing: Equity capital provides the company with creditworthiness and confidence in potential loan providers.

5. No Charge on Assets: Funds can be raised through an equity issue without placing a charge on the company’s current assets. If necessary, a company may freely mortgage its assets in exchange to obtain financing.

6. Democratic Management: The voting rights of equity shareholders ensure democratic control over the company’s management.

Demerits of Equity Shares

1. Risk of Fluctuating Returns: Due to the fluctuating returns on equity shares, investors looking to find a consistent income may not prefer equity shares.

2. High Cost of Capital: The cost of equity shares is typically higher than the cost of raising funds from other sources.

3. Dilution of Control: The voting rights and profits of current equity shareholders are diluted when new equity shares are issued.

4. Legal Formalities: Raising money through the issuance of equity shares involves more formalities and delays in the legal process.

5. Danger of Over-capitalisation: Equity share capital is a permanent source of capital. So, if due to poor financial planning, a company raises excess equity capital, it may get over-capitalised and the equity capital may remain underutilised and idle.