Corporate Equity
27 Feb 2025
A corporation is owned by its shareholders. To own a company means to have certain cash flow rights and control rights. A shareholder has a claim on the company's cash flows (after interest and taxes), and the right to vote on certain company decisions. These rights are split up as soon as the company borrows money.
A young firm looking to raise capital will often turn to venture capitalists. VCs are less risk-averse than banks, and are willing to share the downside risk in case the company fails. They also provide valuable advice and connections. VCs typically invest for the long term, and are willing to wait for a liquidity event (e.g. an IPO) to cash out. Bank loans, on the other hand, require regular interest payments that are due regardless of the company's performance. They also have other requirements, such as collateral and credit profiles that may be difficult for a young firm to meet. Early stage companies are also hard to value, since they have no track record of cash flows. Also, their assets are mostly intangible, consisting of intellectual property and human capital.
The founding process typically goes like this. A set of founders come together to form a company. The initial capital is provided by the founders themselves, or by friends and family. The company spends this initial capital to develop a product and validate the business model. The founders try to answer big picture questions, such as whether the product is technically feasible, whether there is a market for it, and whether the company can make money from it. All these activities drain the company's cash reserves. Eventually, the founders will be out of money, and will need to raise more capital. They approach VCs, and present their business plan to them. If the VCs are convinced, they inject capital into the company, in exchange for equity or ownership rights. The company uses this capital to continue developing its product and validating its business model, and it may or may not raise more capital along the way. This process continues until the company has achieved product-market fit: the product is creating significant value for a specific customer segment, and the company is able to capture some of that value. In other words, the product is addressing a real need, and the company is able to monetize that need. The next focus is on scaling the business, and growing the customer base. More funding rounds may be required to finance this growth.
VC funds are typically structured as limited partnerships. The general partners are the fund managers, who make investment decisions on behalf of the limited partners, which can be pension funds, endowments, family offices, or high net worth individuals. VCs are often well-connected in the industry, and can provide valuable advice and connections to the companies they invest in.
VCs cash in on their investment in several ways. One is through an acquisition by a larger company, who buys the shares of the company from the VCs. Another is through an IPO, where shares of the company are sold to the public.
There are a number of reasons for why a company might want to go public:
Some companies, however, choose to stay private. They may not want to deal with the regulatory burden of being a public company, or they may not want to disclose sensitive information to the public. IPOs are well-known, but it's worth noting that companies can also go the other way: public companies can go private through a process called a leveraged buyout (LBO).
IPOs are typically underwritten by investment banks (other less common methods of going public include direct listings, where existing shares are sold to the public without issuing new shares, and SPACs, where a publicly traded shell company is created to acquire a private company).
The IPO process typically goes like this. The company shops around for an investment bank to underwrite the IPO. Once a bank has been selected, both parties work together to prepare a registration statement, which is filed with the SEC. The investment bank works with other investment banks to form a syndicate, to help with the selling process. The underwriters then generate an estimate of the company's value, by analyzing its assets and cash flows. They also conduct a roadshow, where they pitch the company to potential investors, and collect bids from them. The underwriters use both information to determine a price range for the new issue. The company and the underwriters agree on two prices: the firm commitment price (the price for the underwriters) and the offer/strike price (the initial price for the public). The offer price is typically higher than the firm commitment price, to account for risk on the part of the underwriters. The price cannot be set too high, as this would deter investors from buying the shares. The price cannot be too low either, as this would result in less money raised for the company. Underwriters typically sell more shares than they have committed to buy from the company. If demand is low, then they can buy back shares from the market to help stabilize prices, and sell them again to meet their commitment to institutional investors. If demand is high, then they can exercise their greenshoe option, which entitles them to buy more shares from the company at the offer price. A 40-day quiet period follows the IPO, during which the underwriters cannot issue any recommendations on the stock.
IPOs can be costly for the issuing company. First, there's administrative and legal costs that have to be incurred. Second, there's underwriting spread, the difference between the offer price and the firm commitment price, which is pocketed by the underwriters. Third, there's underpricing, the difference between the offer price and the first day closing price. Underpricing represents a loss of potential capital for the issuing company: they could have raised more capital if the offer price had been set higher, or they could have raised the same amount of capital with fewer shares issued.
Public companies often make further issues to raise more capital. A public offer is very similar to an IPO, except that the company is already listed on the stock exchange. A rights issue is a type of public offer where existing shareholders are given the right to buy new shares at a discount. This is done to prevent dilution of ownership. A private placement is a type of secondary issue where shares are sold to a select group of investors, such as institutional investors or high net worth individuals. Private placements are typically cheaper than public offers, since they don't require the services of an underwriter. Also, no SEC filing is required, since the shares are not sold to the public.
One reason why investors buy shares is that they expect to receive cash payouts from the company. Cash payouts can take the form of dividends or share buybacks.
Dividend payouts begin with a declaration by the company's board of directors. The company announces the amount of the dividend (quoted on a per-share basis), the record date, which is the date on which shareholders must be on the company's books to receive the dividend, and the payment date, which is the date on which the dividend is actually paid. The ex-dividend date is one day before the record date, i.e. the last day on which a shareholder can buy the stock and still receive the dividend. Most companies pay a regular cash dividend each quarter, but occasionally they may pay a one-time special dividend. Some companies also offer a dividend reinvestment plan (DRIP), where shareholders can exchange their cash dividends for additional shares at a discount. Companies may also pay out dividends in the form of stock, rather than cash. Dividend announcements are typically followed by a stock price increase, because they signal future profitability on the part of the company.
Instead of paying dividends, company can use cash to buy back shares. Companies buy back shares for a number of reasons. One is to bypass dividend taxes. Another is to offload excess cash. Reacquired shares are typically held in treasury, and can be reissued at a later date in case the company needs to raise capital again. There are four ways to buy back shares: open market purchases, tender offers (options for shareholders to sell their shares at a fixed and inflated price), Dutch auctions (shareholders submit bids to sell their shares at various prices), and through direct negotiation with a large shareholder. As with dividends, share repurchases signal management's confidence in the company's future prospects. Managers often buy back shares when they believe the stock is undervalued.
Does it matter which form of payout a company chooses? If we disregard market imperfections (i.e. taxes and transaction costs), then it doesn't matter (Miller and Modigliani, 1961). Let's assume a company with 1M oustanding shares, selling at $11 per share, and with $1M in cash. Suppose further that the company is all-equity financed, and that there are no taxes:
If the company pays out $1M, then market cap must fall to $10M. Either the company pays dividends, or it buys back shares. If it pays dividends, then the share price falls to $10 (1M shares with a market cap of $10M). However, there's no change in shareholders' wealth: their shares are now worth $10M in total, but they now have $1M in cash. If the company uses $1M to buy back shares, then share prices remain at $11, but the number of shares outstanding falls to 909,091. Shareholders' wealth is still $11M in total, regardless of whether they decide to sell their shares or not. If they do, they get $11 per share, and if they don't, they still own their shares, which are now worth $11 each. Thus, shareholders are indifferent between dividends and share repurchases.
The example above assumes that the firm has surplus cash. But what if that's not the case? If we assume no change in investment policy and capital structure, then the only way to raise more cash is to issue new shares. But this method can dilute the ownership percentage of existing shareholders. Still, there is no change in shareholders' wealth, because the capital loss from dilution is offset by the extra cash received as dividends.
In theory, management and shareholders should be indifferent between dividends and share repurchases. But this may not hold in practice, where considerations such as taxes, transaction costs, and signalling effects come into play. For instance, capital gains taxes are treated differently from dividend taxes, though the exact difference depends on the specific tax code of the country in question. Management may prefer one over the other for signalling reasons. They may also prefer repurchases to remain flexible, or they may prefer dividends to discipline themselves from careless spending. The same rationale applies to shareholders: some may prefer dividends for the regular income stream, while others may prefer repurchases for the tax advantages.
Although payout policy does not affect shareholder value: it doesn't matter whether a company pays dividends or buys back shares, it does matter when a company decides to pay out its surplus cash. Young firms may be more inclined to reinvest their cash in growth opportunities, while mature firms may be more inclined to pay out their cash to keep their stock prices strong and stable. The following questions can help management decide when to pay out cash:
One worthy mention is opportunity cost. Companies that are cash rich but have no positive NPV projects may be better off paying out their cash to shareholders, who can then invest it in other companies with better growth prospects. Regularly paying out cash is also good corporate governance practice, as it signals to investors that the company is well-managed and has their best interests at heart.