Tag: Consolidated Balance Sheet

An underwriter is a financial institution or individual that guarantees the purchase of any unsold shares in a public offering, such as an Initial Public Offering (IPO) or a Rights Issue. Underwriters play a key role in ensuring that the company raising funds will meet its capital-raising goals, even if the public does not fully subscribe to the offering. They assess the risk, determine pricing, and market the securities. In return for assuming this risk, underwriters are paid a commission, which compensates them for their services and financial commitment to the issue.

Functions of Underwriter:

• Risk Assessment

One of the primary functions of an underwriter is to assess the risk involved in a public offering. Before agreeing to underwrite an issue, the underwriter evaluates the financial health, market conditions, and business prospects of the issuing company. This assessment helps the underwriter determine the likelihood of the offering being successful and identify any potential risks that might affect the sale of shares. Based on this evaluation, they decide whether to underwrite the issue and the terms of underwriting.

• Pricing of Securities

Underwriters play a crucial role in determining the price at which securities are offered to the public. This involves market research, understanding investor demand, and analyzing the company’s financial position. The underwriter sets the issue price to balance the issuer’s goal of raising capital and attracting investor interest. An accurately priced issue ensures that it is neither underpriced (leading to a loss of capital for the issuer) nor overpriced (leading to poor investor demand).

• Marketing and Promotion

Marketing and promotion of the offering is another key function of the underwriter. They are responsible for creating an awareness campaign and ensuring that potential investors are well-informed about the company’s offering. This involves roadshows, presentations, and other promotional activities to generate interest. Underwriters leverage their relationships with institutional and retail investors to ensure the offering is adequately subscribed. Effective marketing directly impacts the success of the offering by creating demand and enhancing visibility.

• Managing Subscription Process

The underwriter is responsible for managing the subscription process during an offering. This includes handling investor applications, collecting payments, and ensuring the shares are allocated correctly. The underwriter coordinates with stock exchanges and regulatory bodies to comply with all procedural requirements. They must ensure that the subscription is conducted smoothly, and that any oversubscription or undersubscription is dealt with effectively, including the allotment of shares to investors as per the rules and regulations.

• Underwriting Commitment

Underwriters provide a guarantee to the issuing company that they will purchase any unsold shares in the event that the public does not fully subscribe to the offering. This is referred to as the underwriting commitment. If the offering is undersubscribed, the underwriter steps in and buys the remaining shares at the agreed-upon price. This commitment ensures that the issuer will raise the desired amount of capital, even if there is low investor interest in the offering.

• Due Diligence

Underwriters are responsible for performing due diligence to ensure that the issuing company’s financials and disclosures are accurate and compliant with regulatory requirements. This includes verifying financial statements, business operations, and legal standing. Due diligence is crucial in protecting investors and ensuring that the information provided in the offer document is truthful and transparent. A thorough due diligence process reduces the risk of legal disputes and protects both the underwriter and the issuer from potential liabilities.

• Stabilization of Market Price

After the securities are issued, the underwriter may be involved in stabilizing the price of the securities in the secondary market. This involves buying and selling shares to prevent excessive price fluctuations immediately after the offering. The underwriter’s role is to ensure that the market price of the shares remains stable and does not fall below the issue price. This helps maintain investor confidence and prevents volatility that could harm the issuer’s reputation and the investors’ interests.

Advantages of Underwriting:

• Capital Guarantee

Underwriting ensures that the company raising capital will receive the full amount of money it requires, even if the public does not fully subscribe to the offering. This capital guarantee helps reduce uncertainty for the issuer, providing confidence that the financial objectives of the offering will be met, regardless of investor demand.

• Expert Guidance

Underwriters bring in-depth market knowledge and expertise, helping the issuing company set the right price for the securities and strategize on how to attract investors. Their experience in market conditions, pricing, and risk management ensures the offering is attractive, thereby maximizing the chances of success for both the company and investors.

• Enhanced Market Credibility

Having a reputable underwriter associated with an issue enhances the company’s credibility in the market. Investors often feel more confident in subscribing to an offering that has been underwritten by well-known financial institutions. This can help increase investor interest and trust, potentially leading to higher subscriptions and a successful offering.

• Risk Mitigation for Issuers

By assuming the risk of underwriting, underwriters protect the issuer from potential losses if the offering is undersubscribed. This is especially important during volatile market conditions where public interest may be lower than expected. The issuer is assured of receiving the required funds, even if the shares do not sell as anticipated.

• Investor Protection

Underwriters perform due diligence to ensure that the information provided in the offer document is accurate, complete, and compliant with regulatory standards. This protects investors by ensuring they have access to reliable and truthful information when making investment decisions. It reduces the likelihood of fraud or misinformation, fostering a safer investment environment.

• Market Liquidity

By underwriting the offering, financial institutions contribute to the liquidity of the stock market. They help ensure that shares are not only sold initially but that they are also available for subsequent trading. This liquidity helps maintain the efficiency and stability of the market, providing investors with opportunities to buy or sell securities as needed.

Disadvantages of Underwriting:

• High Costs

Underwriting involves substantial fees, including commissions paid to the underwriters, as well as legal, administrative, and marketing expenses. These costs can be significant, especially for large public offerings. For smaller companies or those with limited capital, these expenses may be prohibitive and could diminish the funds raised through the offering.

• Underwriter Risk

Underwriters assume a significant amount of financial risk, especially when market conditions are unfavorable. If the public does not subscribe to the offering as expected, the underwriter is left with unsold shares. This risk may lead to financial losses, particularly if the market price of the shares falls below the issue price, impacting the underwriter’s profitability.

• Potential for Overpricing

Underwriters, in their role, set the issue price, which may sometimes be overestimated based on market conditions or overly optimistic projections. Overpricing can lead to poor investor demand, resulting in undersubscription. An improperly priced issue may also harm the company’s reputation, as investors may feel the offering was not accurately valued.

• Conflicts of Interest

In some cases, underwriters may have conflicts of interest. They might prioritize their financial gain over the interests of the issuer or investors. For instance, underwriters may push for a higher issue price or aggressively market the shares to boost their commission, which can negatively affect the long-term success of the company and its stock performance.

• Limited Control for Issuer

Once an underwriter is hired, the company may lose a degree of control over the terms of the offering. The underwriter typically takes the lead in setting the price, timing, and other key aspects of the issue. This can be problematic if the issuer’s vision does not align with the underwriter’s strategies or market approach.

• Increased Regulatory Scrutiny

Underwritten offerings are subject to strict regulatory scrutiny, particularly regarding the due diligence process and disclosure requirements. While this ensures transparency, the complexity and compliance costs can be burdensome for the issuer. Regulatory bodies, such as SEBI in India or the SEC in the U.S., monitor the underwriting process closely, increasing the time and effort needed to complete the offering.

Shares represent units of ownership in a company, allowing investors to hold a stake in the business. Companies issue shares to raise capital for operations, expansion, or debt repayment. Shareholders receive returns in the form of dividends and capital appreciation. There are two main types: equity shares, which provide voting rights and variable dividends, and preference shares, which offer fixed dividends with priority over equity shareholders. Shares are traded in stock markets, where their value fluctuates based on company performance and market conditions. Owning shares provides limited liability, meaning investors risk only their invested amount.

Equity Shares

Equity shares represent ownership in a company, giving shareholders voting rights and a share in profits through dividends. These shares are issued to raise long-term capital and fluctuate in value based on market performance. Equity shareholders are considered residual claimants, meaning they receive returns after all liabilities and preference dividends are paid. They carry higher risk but offer higher returns. Equity shares provide limited liability, meaning shareholders are only liable up to their investment. Companies issue them in different classes, such as ordinary or differential voting rights (DVR) shares.

Features of Equity Shares:

• Ownership Rights

Equity shares represent ownership in a company, giving shareholders a claim on assets and profits. Shareholders are considered partial owners and have voting rights to influence corporate decisions. The extent of ownership depends on the number of shares held. This ownership provides shareholders with the ability to participate in key decisions such as mergers, acquisitions, and board member elections. Since equity shareholders are the last to receive payments in case of liquidation, their claim on company assets comes after creditors and preference shareholders. This ownership gives them the highest risk but also the highest rewards.

• Voting Power

Equity shareholders have the right to vote on important corporate matters, making them influential stakeholders. Their voting power is proportional to the number of shares they own. They can vote on electing board members, approving mergers, and other strategic business decisions. Some companies also issue Differential Voting Rights (DVR) shares, which offer lower or higher voting power than regular shares. Although retail investors often do not participate in voting, institutional investors play an active role. Shareholders can also vote via proxies, allowing others to vote on their behalf in company meetings.

• Dividends Based on Profits

Unlike preference shares, equity shares do not guarantee fixed dividends. Instead, dividends depend on the company’s profitability. If a company performs well, it may distribute high dividends; if it incurs losses, it may choose not to distribute dividends at all. Companies usually pay dividends annually or quarterly, but there is no obligation to do so. Dividend payments are decided by the board of directors and approved by shareholders. Some companies reinvest profits into growth instead of paying dividends, benefiting shareholders through stock price appreciation in the long run.

• Residual Claim in Liquidation

Equity shareholders are considered residual claimants, meaning they receive their share of assets only after all liabilities, creditors, and preference shareholders have been paid in the event of liquidation. This makes equity shares riskier than other forms of investment. If a company goes bankrupt, there is no guarantee that equity shareholders will receive anything. However, if the company has sufficient assets left after paying debts, equity shareholders can claim their portion. While this poses a financial risk, it also provides the potential for high returns if the company performs well over time.

• High-Risk, High-Return Investment

Equity shares are considered a high-risk, high-return investment. Their prices fluctuate based on company performance, market conditions, and investor sentiment. Unlike bonds or preference shares, equity shares do not provide fixed returns. Investors may experience significant capital appreciation if the company grows, but they may also face losses if it underperforms. The risk factor is influenced by economic conditions, industry trends, and regulatory changes. Long-term investors often benefit from market growth, while short-term traders take advantage of price volatility. Equity shares suit investors who can tolerate financial risk for potential higher rewards.

• Limited Liability

Equity shareholders enjoy limited liability, meaning their financial risk is restricted to the amount they have invested in the company. If the company incurs losses or goes bankrupt, shareholders are not personally responsible for repaying debts beyond their investment. Unlike sole proprietors or partners, shareholders do not risk their personal assets. This makes equity shares an attractive investment option, as investors can participate in business growth without worrying about unlimited financial exposure. However, while their liability is limited, the value of their shares can fluctuate significantly based on market conditions.

Preference Shares

Preference Shares provide shareholders with a fixed dividend before equity shareholders receive any dividends. They combine features of equity and debt, offering stable income with limited voting rights. In case of liquidation, preference shareholders have a higher claim on assets than equity shareholders. These shares come in various forms: cumulative, non-cumulative, convertible, non-convertible, redeemable, and irredeemable. Preference shares are ideal for investors seeking steady returns without ownership control. Companies use them to attract conservative investors who prefer lower risk over potentially higher but uncertain equity returns.

Features of Preference Shares:

• Fixed Dividend Payout

Preference shareholders receive a fixed dividend, unlike equity shareholders whose dividends fluctuate based on company profits. This makes preference shares a stable income source, attracting risk-averse investors. The dividend rate is pre-determined at the time of issuance, ensuring predictable returns. Even if a company earns high profits, preference shareholders receive only the fixed dividend, while equity shareholders benefit from profit surges. This fixed nature makes preference shares similar to bonds, offering regular income with lower volatility. However, dividends are paid only if the company has distributable profits.

• Priority in Dividend Payment

Preference shareholders have the advantage of receiving dividends before equity shareholders. If a company declares dividends, preference shareholders are paid first, ensuring consistent returns. This priority makes preference shares more attractive to investors seeking steady income with lower risk. Even if a company faces financial difficulties, preference shareholders still have a better chance of getting paid than equity shareholders. This feature provides financial security for investors, making preference shares an ideal choice for those who prefer stability over the uncertainty of fluctuating dividends.

• Priority in Liquidation

In case of a company’s liquidation, preference shareholders have a higher claim on assets than equity shareholders. After repaying debts and liabilities, preference shareholders receive their dues before any distribution is made to equity shareholders. This reduces the risk associated with investment in shares, as preference shareholders are more likely to recover their funds if the company goes bankrupt. However, they rank below creditors, meaning they will only be paid if funds remain after settling debts. This makes preference shares a safer investment compared to equity shares.

• Limited or No Voting Rights

Unlike equity shareholders, preference shareholders generally do not have voting rights in company decisions. They cannot vote on management policies, mergers, or business strategies. However, in special cases, such as when dividends are unpaid for a certain period, preference shareholders may gain voting rights. Some companies issue preference shares with limited voting rights, allowing shareholders to participate in specific corporate matters. This feature makes preference shares more like debt instruments, offering financial benefits without significant control over the company’s decision-making process.

• Convertible and Non-Convertible

Preference shares can be classified as convertible or non-convertible. Convertible preference shares can be converted into equity shares after a specified period or under certain conditions, offering investors the potential for capital appreciation. This makes them attractive for investors looking for both stability and long-term growth opportunities. On the other hand, non-convertible preference shares remain as preference shares throughout their tenure, providing fixed dividends without conversion benefits. Investors choose based on their risk appetite—convertible shares for growth potential and non-convertible shares for stable income.

• Redeemable and Irredeemable Options

Preference shares can be redeemable, meaning the company repurchases them after a fixed period, or irredeemable, meaning they exist indefinitely. Redeemable preference shares provide companies with financial flexibility, as they can buy back shares when it is financially viable. This benefits investors by offering a guaranteed return of principal after a set period. Irredeemable preference shares, however, remain part of the company’s capital structure indefinitely, ensuring long-term dividend income. Companies issue different types based on their financial strategies and investor preferences.