Understanding Financial Management and Securities Markets
141 Equity Financing
- When and how do firms issue equity, and what are the costs?
Equity refers to the owners’ investment in the business. In corporations, the preferred and common stockholders are the owners. A firm obtains equity financing by selling new ownership shares (external financing), by retaining earnings (internal financing), or for small and growing, typically high-tech, companies, through venture capital (external financing).
Selling New Issues of Common Stock
Common stock is a security that represents an ownership interest in a corporation. A company’s first sale of stock to the public is called an initial public offering (IPO). An IPO often enables existing stockholders, usually employees, family, and friends who bought the stock privately, to earn big profits on their investment. (Companies that are already public can issue and sell additional shares of common stock to raise equity funds.)
But going public has some drawbacks. For one thing, there is no guarantee an IPO will sell. It is also expensive. Big fees must be paid to investment bankers, brokers, attorneys, accountants, and printers. Once the company is public, it is closely watched by regulators, stockholders, and securities analysts. The firm must reveal such information as operating and financial data, product details, financing plans, and operating strategies. Providing this information is often costly.
Going public is the dream of many small company founders and early investors, who hope to recoup their investments and become instant millionaires. Google, which went public in 2004 at $85 a share and soared to $475 in early 2006 before settling back to trade in the high-300 range in August 2006. More than a decade later, in October 2017, Google continues to be a successful IPO, trading at more than $990 per share.
In recent years, the number of IPOs has dropped sharply, as start-ups think long and hard about going public, despite the promise of millions of dollars for investors and entrepreneurs. For example, in 2017, Blue Apron, a meal-kit delivery service, went public with an opening stock price of $10 per share. Several months later, the share price dropped more than 40 percent. Some analysts believe that Amazon’s possible entry into the meal-kit delivery sector has hurt Blue Apron’s value, as well as the company’s high marketing costs to attract and retain monthly subscribers.
Some companies choose to remain private. Cargill, SC Johnson, Mars, Publix Super Markets, and Bloomberg are among the largest U.S. private companies.
Dividends and Retained Earnings
Dividends are payments to stockholders from a corporation’s profits. Dividends can be paid in cash or in stock. Stock dividends are payments in the form of more stock. Stock dividends may replace or supplement cash dividends. After a stock dividend has been paid, more shares have a claim on the same company, so the value of each share often declines. A company does not have to pay dividends to stockholders. But if investors buy the stock expecting to get dividends and the firm does not pay them, the investors may sell their stocks.
At their quarterly meetings, the company’s board of directors (typically with the advice of its CFO) decides how much of the profits to distribute as dividends and how much to reinvest. A firm’s basic approach to paying dividends can greatly affect its share price. A stable history of dividend payments indicates good financial health. For example, cable giant Comcast has increased its dividend more than 20 percent over the past five years, giving shareholders a healthy return on their investment.
If a firm that has been making regular dividend payments cuts or skips a dividend, investors start thinking it has serious financial problems. The increased uncertainty often results in lower stock prices. Thus, most firms set dividends at a level they can keep paying. They start with a relatively low dividend payout ratio so that they can maintain a steady or slightly increasing dividend over time.
Retained earnings, profits that have been reinvested in the firm, have a big advantage over other sources of equity capital: They do not incur underwriting costs. Financial managers strive to balance dividends and retained earnings to maximize the value of the firm. Often the balance reflects the nature of the firm and its industry. Well-established and stable firms and those that expect only modest growth, such as public utilities, financial services companies, and large industrial corporations, typically pay out much of their earnings in dividends. For example, in the 2016 fiscal year, ExxonMobil paid dividends of $3.08 per share, Altria Group paid $2.64 per share, Apple paid $2.23 per share, and Costco paid $2.00 per share.
Most high-growth companies, such as those in technology-related fields, finance much of their growth through retained earnings and pay little or no dividends to stockholders. As they mature, many decide to begin paying dividends, as Apple decided to do in 2012, after 17 years of paying no annual dividends to shareholders.
Another form of equity is preferred stock. Unlike common stock, preferred stock usually has a dividend amount that is set at the time the stock is issued. These dividends must be paid before the company can pay any dividends to common stockholders. Also, if the firm goes bankrupt and sells its assets, preferred stockholders get their money back before common stockholders do.
Like debt, preferred stock increases the firm’s financial risk because it obligates the firm to make a fixed payment. But preferred stock is more flexible. The firm can miss a dividend payment without suffering the serious results of failing to pay back a debt.
Preferred stock is more expensive than debt financing, however, because preferred dividends are not tax-deductible. Also, because the claims of preferred stockholders on income and assets are second to those of debtholders, preferred stockholders require higher returns to compensate for the greater risk.
Venture capital is another source of equity capital. It is most often used by small and growing firms that aren’t big enough to sell securities to the public. This type of financing is especially popular among high-tech companies that need large sums of money.
Venture capitalists invest in new businesses in return for part of the ownership, sometimes as much as 60 percent. They look for new businesses with high growth potential, and they expect a high investment return within 5 to 10 years. By getting in on the ground floor, venture capitalists buy stock at a very low price. They earn profits by selling the stock at a much higher price when the company goes public. Venture capitalists generally get a voice in management through seats on the board of directors. Getting venture capital is difficult, even though there are hundreds of private venture-capital firms in this country. Most venture capitalists finance only about 1 to 5 percent of the companies that apply. Venture-capital investors, many of whom experienced losses during recent years from their investments in failed dot-coms, are currently less willing to take risks on very early-stage companies with unproven technology. As a result, other sources of venture capital, including private foundations, states, and wealthy individuals (called angel investors), are helping start-up firms find equity capital. These private investors are motivated by the potential to earn a high return on their investment.
- Compare the advantages and disadvantages of debt and equity financing.
- Discuss the costs involved in issuing common stock.
- Briefly describe these sources of equity: retained earnings, preferred stock, venture capital.
Summary of Learning Outcomes
- When and how do firms issue equity, and what are the costs?
The chief sources of equity financing are common stock, retained earnings, and preferred stock. The cost of selling stock includes issuing costs and potential dividend payments. Retained earnings are profits reinvested in the firm. For the issuing firm, preferred stock is more expensive than debt because its dividends are not tax-deductible and its claims are secondary to those of debtholders but less expensive than common stock. Venture capital is often a source of equity financing for young companies.
- common stock
- A security that represents an ownership interest in a corporation.
- Payments to stockholders from a corporation’s profits.
- preferred stock
- An equity security for which the dividend amount is set at the time the stock is issued and the dividend must be paid before the company can pay dividends to common stockholders.
- retained earnings
- Profits that have been reinvested in a firm.
- stock dividends
- Payments to stockholders in the form of more stock; may replace or supplement cash dividends.