You probably often read the news of a company becoming public or issuing shares to the public as IPO. An obvious question arises after reading this type of news is, why a company goes public or why the company shares its profit with investors when it can keep all the profit itself working as a private entity?
The answer to this question is, companies issue shares because they need more money to finance their expansion and to function efficiently.
The investor buying these shares get part ownership in the company and company gets the needed money which it can use for its operations.
Debt financing vs equity financing
A company can also take a loan from banks or can borrow by issuing bonds to raise this capital. This route of financing by taking credit or issuing bond is a ‘debt financing.’
While raising money by issuance of shares are called ‘equity financing.’
In debt financing companies need to return the raised capital with interest payable on it.
On the other hand, the fund raised through equity financing provides more freedom to use this capital as it does not carry interest on it. And this money does not need to be paid back.
Why investors buy stocks
In ‘equity financing’ companies raise money by selling part ownership of it in the form of shares to the investors.
Shares are the certificate of partial ownership in the company. Issuing shares to new investors decrease the ownership percentage of promoters and previous shareholders in the company.
Investors buying shares are the part owners of the business. They buy shares in the hope of the company becoming successful in the future so the price of their shares will appreciate.
Companies also share their profit with investors in the form of a dividend.
But being a partial owner of the business also exposes investors to the risk of business not being successful.
Sometimes companies do not perform well. In that case, the price of their shares may drop in the stock market. Or even worse, a company can go bankrupt, in that case, investors can lose their entire invested capital.
Read also: Definition of portfolio
Companies can issue the different type of shares as per their need. These shares come with varying rights to investors. ‘Common stocks’ and ‘Preference stocks’ are two commonly issued stocks.
When people talk about stocks they are most likely referring to common stocks.
Common stocks represent the ownership in the company and come with voting rights of one vote per share (in most cases).
Common stockholders use their voting rights in some significant corporate matters as to select board members and approving/disapproving the proposed merger.
The company pays a dividend on common stock, but it is not always guaranteed. However, in case of the business being successful, common stocks appreciate maximum in value.
But the other side of the coin is that if the company goes bankrupt, common stockholders will bear the maximum loss, as common stockholders have the last claim on the company’s assets after creditors and preference shareholders. In most cases, common stockholders lose their entire invested capital in case the company goes bankrupt.
Preferred stocks resembles bonds to some extent and do not come with voting rights (in most cases). Preferred stockholders are promised a fixed dividend, opposite to common stocks in which investors are not guaranteed a dividend (Most companies pay a small dividend or no dividend at all to common stockholders).
Another advantage of preferred stocks is, in case of bankruptcy preferred stockholders get a claim on the assets before the common stockholders (but after creditors). Preferred stockholders have a preference on dividend and on assets that’s why they are called preferred.
Preferred stocks may be ‘callable’ or ‘putable.’ Some preferred stocks can be convertible that can be converted into common stocks.