Within the broader capital market, the equity capital market is a platform where financial institutions, companies, and investment banking engage in trading financial instruments and seek to raise capital for businesses.
Unlike debt markets, equity capital markets carry an elevated level of risk, which, in turn, offers the potential for increased returns.
Instruments Traded in the Equity Capital Market
Equity capital is obtained by selling a portion of ownership rights to a company's assets in exchange for funds.
The value of equity capital is determined by the company's existing assets and business performance. Instruments traded in the equity capital market include:
Common shares
Common shares represent ownership capital, entitling shareholders to dividends from profits. Common shareholders have residual claims to income and assets after preferred shareholders and bondholders.
Private equity
Due to limited access to bank capital or public equity markets, startups and smaller companies commonly use equity investments through private placements. Investors are commonly institutional investors or wealthy individuals.
Global Depository Receipts (GDRs):
These are negotiable receipts issued against shares of foreign companies by financial institutions in developed countries.
Futures
Futures are exchange-traded contracts for buying/selling assets at predetermined future dates and executed through clearinghouses, acting as intermediaries and ensuring contract compliance.
Options
Options are contracts providing the right (not obligation) to buy or sell underlying assets by a specified date, with a premium paid. Call options grant the right to buy, while put options grant the right to sell.
Functions of an Equity Capital Market
The various vital functions equity capital market performs are:
- Facilitating issue marketing: The equity capital market is crucial in promoting and marketing new securities issues to potential investors. It involves creating awareness, generating interest, and distributing information about available investment opportunities.
- Managing issue distribution: The market facilitates the issuance of securities by companies or other entities to investors. It connects buyers and sellers, ensuring the efficient transfer of ownership rights and the smooth execution of transactions.
- Allocating new issues: For new securities offerings, such as IPOs or private placements, the equity capital market helps distribute these newly issued securities to interested investors. It ensures a fair and efficient distribution of the securities through appropriate pricing and relevant allocation strategies.
- Supporting initial public offerings (IPOs): The equity capital market provides a platform for companies to go public through IPOs. It assists in listing a company's shares on a stock exchange, enabling it to raise capital from public investors and transition from private to public ownership.
Advantages and Disadvantages of Raising Capital in Equity Markets
Advantages of Equity Financing
Unburdened assets
Equity investors do not require collateral for their investments. It means the company's assets remain unencumbered and can secure loans if needed.
Additionally, assets acquired using equity capital can be used as collateral for future long-term debt.
Freedom from financial commitment
Unlike lenders who impose financial commitment to ensure loan repayment, equity investors do not impose such restrictions. Instead, they rely on governance rights to protect their interests.
It grants the company greater flexibility in using funds without the constraints of financial contracts.
Disadvantages of Equity Financing
Investor expectations
Equity investors need more certainty regarding profits, business growth, and dividends than debt holders. Consequently, equity investors expect a higher return on their investment to compensate for the increased risk.
Regulatory compliance and governance rights
Equity financing is subject to legal regulations and structures governing financing transactions.
Equity investors possess financial rights, including entitlement to dividends and company sale proceeds. They also hold governance rights related to board elections and significant business decisions.
These rights dilute ownership and control, leading to increased oversight of management decisions.
What Is an Equity Offering?
An equity offering involves publicly selling a company's shares to raise capital. It can be an IPO, SPAC IPO, FPO, or Secondary Offering. The primary objective remains capital generation, enabling companies to pursue acquisitions, fund growth initiatives, or manage debt.
Types of Equity Offerings and Financing Types
Some of the common equity offerings are:
At-the-market offering
An at-market offering occurs when a company sells its shares in the open market through an equity dealer. It is typically executed over time, introducing uncertainty regarding the funds raised.
Bought-out deal
A bought-out deal involves an investment bank purchasing the entire equity offering from the company and selling it to investors gradually. This method saves the issuing company costs and time associated with a public issue.
Direct public offering
In a direct public offering (DPO), a company sells its equity directly to the public without involving an investment bank. This approach differs from most equity offerings relying on intermediaries.
Exchangeable security
Exchangeable securities are equity instruments convertible into another security in the future, usually at a predetermined price. They enable companies to raise capital without issuing new equity outright.
Pre-IPO financing
Pre-IPO financing entails raising funds from investors before a company goes public. This financing is often used for growth or to cover expenses related to the IPO process.
Public offering
A public offering involves the sale of a company's equity to the public. It can occur through an IPO or a secondary offering.
Reverse merger
In a reverse merger, a private company acquires a public company, allowing it to list its shares on a stock exchange without undergoing an IPO.
Underwritten public offering
Unlike a self-managed equity offering, an underwritten public offering occurs when a company sells equity to the public with an investment bank’s assistance.
Underwriting
Underwriting refers to the support provided by an investment bank to help a company sell equity to the public. It involves determining the equity price and facilitating the sale to investors.
Conclusion
The equity capital market (ECM) is a critical component of the capital market, facilitating financial instrument trade and capital-raising for enterprises. Investment banking professionals in ECM groups handle transactions such as initial public offerings and equity offerings.
Equity financing offers diverse funding options and long-term growth potential but dilutes ownership and lacks tax advantages.
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