External sources of finance come from outside the business. Share issue belongs to external sources of finance. When businesses need to use the money in the long term (more than five years), this creates the need for long-term finance.
The amount of long-term finance needed for buying Fixed Assets, or Non-Current Assets, with a relatively low value such as vehicles will be small. While the amount of long-term finance needed for buying Fixed Assets, or Non-Current Assets, with a relatively high value such as new machinery for the assembly line will be large.
1. Share issue
Share issue is the process by which limited companies pass on new shares to investors. All limited companies issue shares at the beginning when they are established. Investors purchase shares in order to become co-owners of an incorporated business.
The money from investors injected into the business is permanent capital which will never be returned. The finance raised will be used for business growth – buying Fixed Assets, inventing new products, hiring new workers, etc.
Only limited companies are able to sell shares to raise money from investors.
Which businesses can issue shares?
Share issue is only available to limited liability companies such as private limited companies (ltd.) and public limited companies (plc). Only these two forms of legal structure allow to raise finance through share issue.
Private limited companies can only sell shares privately to existing shareholders or family members and friends.
Conversion from a private limited company to a public limited company can increase the pool of potential investors. It is because, public limited companies can sell shares via the stock markets to the general public. So, anyone in the world can buy shares in plcs.
Benefits of share issue
- Can raise substantial amounts of finance. Share capital is the money raised by a business from selling shares in the company. The amount of finance raised in this way is usually huge. In addition to share issue (selling a part of the business to investors), most of the limited companies will raise finance from long-term bank loans and by issuing bonds.
- Can raise more finance anytime. Existing limited companies can conveniently raise additional finance by selling more shares to the current internal shareholders. Or, they can also issue shares to new investors from outside of the business.
- Capital never has to be repaid. All the money generated for the business through share issue, does not, and will not have to be repaid. The capital injected into the company will be recorded as Total Shareholders’ Equity on the Balance Sheet. Total Shareholders’ Equity together with Retained Earnings will account for Equity, or Wealth, of the company. Shareholders will never get their investments back, but they can easily sell their shares to others.
Drawbacks of share issue
- Loss of ownership and control. When a limited company issues shares, the ownership of the business becomes diluted as there are more owners now. This means that each one share will account for lower percentage of the ownership. By issuing too many shares, current owners can even lose control of the business especially when competitors buy those shares.
- Full disclosure of financial information. All public limited companies are required by law to make their final accounts available to the general public. These final accounts must be accurate, compete and up-to-date in accordance with relevant securities laws. In this way, investors gain access to quarter and annual Profit and Loss Accounts (P&L), Balance Sheets and Cash Flow Statements, so make informative decisions. However, competitors and other stakeholders can obtain sensitive financial information when disclosed.
- Going public is costly and complicated. Many private limited companies decide to ‘go public’ by floating their shares on a stock market. This process is known as an Initial Public Offering (IPO). By converting into a public limited company, a private limited company can raise much more capital by attracting more investors globally than from just the existing shareholders. However, the IPO process involves many legalities and administrative procedures which require high expenses. Usually investment banks are involved as underwriting banks, such as The Goldman Sachs Group or JPMorgan Chase & Co., to help the private limited company prepare for its Initial Public Offering (IPO). Also, auditors, accountants, lawyers and Securities and Exchange Commission (SEC) experts must be involved to discuss details of the offering.
In summary, selling shares can generate large amounts of finance for a growing business organization. All the capital raised through issuing shares becomes permanent capital of the business.
