Market for raising equity capital and trading financial instruments
Written byTim Vipond
What is the Equity Capital Market?
The equity capital market is a subset of the broader capital market, where financial institutions and companies interact to trade financial instruments and raise capital for companies. Equity capital markets are riskier than debt markets and, thus, also provide potentially higher returns.
Instruments Traded in the Equity Capital Market
Equity capital is raised by selling a part of a claim/right to a company’s assets in exchange for money. Thus, the value of the company’s current assets and business define the value of its equity capital. The following instruments are traded on the equity capital market:
Common stock shares represent ownership capital, and holders of common shares/stock are paid dividends out of the company’s profits. Common shareholders have a residual claim to the company’s income and assets. They are entitled to a claim in the company’s profits only after the preferred shareholders and bondholders have been paid.
The earnings available to common shareholders (EAS) are given by the following formula:
Earnings Available to Shareholders (EAS) = Profit after Tax – Preferred Dividend
Note: Profit after Tax = Operating profits (/Earnings before Interest and Tax) – Tax
The variability in the returns of shareholders depends on the company’s debt-to-equity ratio. The higher the proportion of debt financing, the fewer the number of shares with claims to the company’s profits. If the profits exceed the interest payments, the excess profit is distributed to shareholders. However, if the interest payments exceed the profits, the loss is distributed to shareholders. The higher the debt-to-equity ratio, the higher will be the variability in the payment of dividends (and vice versa).
However, common shareholders have no legal right to be paid a dividend. Thus, the dividend paid depends on the discretion of management. Similarly, in the event of liquidation, the shareholder’s claim to the company’s asset ranks after that of creditors and preferred shareholders. Thus, common shareholders face a higher degree of risk than other creditors of the company but also have the prospect of higher returns.
Preferred shares are a hybrid security because they combine some features of debentures and common equity stock. They are like debentures because they have a fixed/stated rate of dividends, have a claim to the company’s income and assets before equity, do not have a claim in the company’s residual income/assets, and do not confer voting rights to shareholders.
However, just like a common equity dividend, preferred dividends are not tax-deductible. The various types of preferred shares are irredeemable preferred shares, redeemable preferred shares, cumulative preferred shares, non-cumulative preferred shares, participating preferred shares, convertible preferred shares, and stepped preferred shares.
Private equity
Equity investments made through private placements are known as private equity. Private equity is raised by private limited enterprises and partnerships, as they cannot trade their shares publicly. Typically, start-up and/or small/medium-sized companies raise capital through this route from institutional investors and/or wealthy individuals because:
- They have limited access to bank capital due to the unwillingness of banks to lend to an enterprise with no proven track record; or,
- They have limited access to public equity on account of not having a large and active shareholder base.
- Venture capital funds, leveraged buyouts, and private equity funds represent the most important sources of private equity.
American depository receipts (ADR)
An ADR is a certificate of ownership issued in the name of a foreign company by an American bank, against the foreign shares deposited in the bank by the said foreign company. The certificates are tradeable and represent ownership of shares in a foreign company.
ADRs promote the trading of foreign shares in America by admitting the shares of foreign companies into a well-developed stocked market. They often represent a combination of many foreign shares (for instance, lots of 100 shares). ADRs and their associated dividends are denominated in US dollars.
Global depository receipts (GDRs)
Global depository receipts (GDRs) are negotiable receipts that are issued against the shares of foreign companies by financial institutions situated in developed countries.
Futures
A futures contract is a forward contract traded on an organized exchange. They are entered into and executed through clearinghouses. Thus, clearinghouses act as intermediaries between the buyer and seller of the futures contract. The clearinghouse also guarantees that both parties adhere to the contract.
Options
A one-sided contract, an option provides one party with the right but not the obligation to sell or buy the underlying asset on or before a pre-determined date. To acquire this right, a premium is paid. An option to buy is known as a call option, while an option that confers the right to sell is known as a put option.
Swaps
A swap is a transaction under which one stream of cash flow is exchanged for another between two parties.
Functions of an Equity Capital Market
The equity capital market acts as a platform for the following functions:
- Marketing of issues
- Distribution of issues
- Allocating new issues
- Initial public offerings (IPOs)
- Private placements
- Trading derivatives
- Accelerated book-building
Participants in the Equity Capital Market
Large-cap, mid-cap, and small-cap companies can be listed on the equity capital market. Investment bankers, retail investors, venture capitalists, angel investors, and securities firms are the dominant traders on the ECM.
Structure of the Equity Capital Market
The equity capital market can be divided into two parts:
Primary equity market
Allows companies to raise capital from the market for the first time. It is further divided into two parts:
1. Private placement market
The private placement market allows companies to raise private equity through unquoted shares. It provides a platform where companies can sell their securities to investors directly. In this market, companies do not need to register securities with the Securities and Exchange Commission (SEC), as they are not subject to the same regulatory requirements as listed securities. Typically, the private placement market is illiquid and risky. As a result, investors in this market demand a premium as compensation for their risk-taking and the lack of liquidity in the market.
2. Primary public market
The primary public market deals with two activities:
- Initial Public Offerings (IPO): An IPO refers to the process by which a company issues equity publicly for the first time and becomes listed on the stock exchange.
- Seasoned Equity Offering (SEO)/Secondary Public Offering (SPO): An SEO/SPO is the process by which a company that is already listed on the stock exchange issues new/additional equity.
When a firm issues stock on the stock exchange, it may do so without creating new shares, i.e., it may exchange unquoted stock for quoted stock. In such a case, the initial investor receives the proceeds earned by selling the newly quoted shares.
However, if the company creates new shares for the issue, the proceeds from the sale of those shares are credited to the company. Furthermore, investment banks are major players in the primary public market because both IPOs and SEOs/SPOs require their underwriting services.
Secondary equity market
The secondary equity market provides a platform for the sale and purchase of existing shares. No new capital is created in the secondary equity market. The holder of the security, and not the issuer of the traded security, receives proceeds from the sale of the security in question. The secondary equity market can be further divided into two parts:
1. Stock exchanges
A stock exchange is a central trading location where the shares of companies listed on the stock exchange are traded. Each stock exchange has its own criteria for listing a company on its exchange. The most commonly used criteria are:
- Minimum earnings
- Market capitalization
- Net tangible assets
- Number of shares held publicly
2. Over-the-counter (OTC) markets
The OTC market is a network of dealers who facilitate the trading of stocks bilaterally between two parties without a stock exchange acting as an intermediary. The OTC markets are not centralized and organized. Thus, they are easier to manipulate than stock exchanges.
Advantages of Raising Capital in the Equity Capital Market
Raising capital in the equity market provides a company with the following advantages:
- Reduction of credit risk: The higher the proportion of equity in the company’s capital structure, the lesser the amount of debt it has to raise. As a result, credit risk is reduced.
- Greater flexibility: A lower debt to equity ratio allows greater flexibility in the firm’s operation. This is because shareholders are less risk-averse than debt holders, given that the former stand to gain more if the company makes a large profit (in the form of greater dividends) and face limited losses if the company does poorly (because of limited liability).
- Signaling Effect: Issuing equity also signals that the company is doing well financially.
Disadvantages of Raising Capital in the Equity Capital Market
A company faces the following disadvantages by raising capital in the equity market:
- Dividend payments are not tax-deductible: Unlike interest on debt, dividend payments are not tax-deductible.
- The company is subject to greater scrutiny: Investors in the equity market rely very heavily on the company’s financial statements to make their investment decisions. Thus, the company and its financial statements are subject to more stringent disclosure norms and scrutiny.
- Shareholder dependence: Maintaining a low debt-to-equity ratio means that a larger number of shareholders have a claim to the company’s profits. As a result, the company may have to reduce its retained earnings, even if it results in lower profits in the long run, to pay a competitive dividend to the shareholders in the short run.
Additional Resources
ECM Deals Committee
Earnings per Share Formula
Debt to Equity Ratio Formula
Private Equity in China – Process, Opportunities and Challenges
See all valuation resources
See all equities resources
