Why Do Companies Issue Shares?
Companies need to raise money to support the ongoing growth of the company – to do this they need to either borrow money, or sell part of the company. As each share is a small part of the company, the latter option is issuing shares.
Debt financing
Debt financing is the first option – borrowing money to expand. Companies either take out a loan from a bank, or borrow money from bond holders for a fixed period (i.e.: issuing bonds).
Those who buy a debt investment in a company, in this case the banks for the bond holders, they are guaranteed the return of their investments, known as the principal, along with interest payments stated at the outset of the investment.
This is similar to taking out a mortgage – if a new homeowner takes out a mortgage, the bank makes a debt investment in the homeowner. If the mortgage is for cost $300,000, the bank is guaranteed the return of that $300,000, along with monthly interest charges.
Equity financing
Equity financing is the second option – issuing shares. The advantage of issuing shares over debt financing is that the company is not required to pay back the money or make interest payments.
In return for investing in the shares, shareholders hope that the value of the company will rise and they will be able to sell the shares for a higher price than what they paid for them. This means that shareholders take on the risk that the company’s value may not go up, and the value of the shares will be less than what was paid for them.
If a company goes into liquidation, the debt financers will have a higher claim to the company’s assets than equity financers, meaning that banks and bond holders have a higher claim to the assets than shareholders. This could result in shareholders losing their entire investment.
Issuing new shares
When a company first issues shares, this is known as the Initial Public Offering.
A company may also issue new shares throughout its existence, perhaps because additional equity is required, either for further expansion or to distribute among current investors so they may benefit in the company’s future success; or it may issue shares as part of an employee bonus scheme.
Risks of share trading
Investing in shares does not guarantee a profit – some companies pay dividends to shareholders, and some do not. Some companies will increase in value, and some may not. However, the positive side of taking on risk is that risk offers greater return on your investments – traditionally, shares have had an average long-term return of about 10-12% of the initial investment, which is much higher than bonds or savings accounts.
