Tuesday, November 9, 2010

An Introduction to Equity Capital Markets Transactions

In recent years, the Sultanate has experienced tremendous growth not only of its national economy and physical infrastructure, but also of its financial system. Oman’s capital markets, in particular, have undergone significant development and modernisation since the legislation passed in 1998 to restructure the Muscat Securities Market.

Equity capital markets transactions, such as IPOs and rights offerings, are key events for the companies that undertake them, and such transactions often take on a larger importance to a nation’s economy and financial system. Yet these transactions tend to be shrouded in so much jargon and mystery that they sometimes can be difficult for laymen, and even experienced businessmen, to understand. Our mission in this article, and in the further articles on capital markets transactions in coming issues of the Client Alert, is to explain how these transactions work and why they are important to companies.

This article describes, at a fundamental level, what equity capital markets transactions are and why companies undertake them. Future Oman Blog posts will explore these transactions in further detail.

What is an Equity Capital Markets Transaction?

An equity capital markets transaction is essentially a sale of stock – ownership shares – in a company to investors. Investors buy stock in a company in order to receive a share of the dividends that the company pays out to its shareholders periodically, or in order to make a profit by later selling the stock to another investor for a higher price.

Large investors may also buy stock in a company with the goal of influencing – or even gaining control over – the management of the company. An investor, or group of investors, that acquires a large percentage of the company’s (voting) stock can vote its representatives onto the company’s board of directors and influence the selection of the company’s management. (Note that some companies have multiple classes of stock, with some classes carrying voting rights, and other classes carrying only economic rights such as the right to receive dividends or the right to be bought out at a specified time and price.)

There are different varieties of equity capital markets transactions, categorised according to who is selling the shares (e.g., the company itself, or its existing shareholders) and to whom the shares are sold (e.g., to existing shareholders, to private institutional investors, or to the investing public).

However, the most well-known type of equity capital markets transaction is an initial public offering, or IPO. In an IPO, the company “lists” its shares – that is, makes them tradable on a stock exchange – and creates and sells additional shares of the company to the investing public.

Another common type of equity capital markets transaction is a rights offering. In a rights offering, a company offers each of its existing shareholders the right to buy additional shares in the company at a specified price within a specified time period. (See the May 2010 blog post on rights offerings and their use in meeting Oman’s increased capitalisation requirements.)

Why do Companies Engage in Equity Capital Markets Transactions?

One of the most fundamental needs of any company is capital. A company needs capital in order to function – to fund the costs of starting up the business; to provide a cushion for the company’s finances during temporary gaps in cash flows; and to fund expansion plans such as hiring more workers, building new facilities or making acquisitions.

Companies can raise capital either by selling stock in the company (i.e., issuing equity) or by borrowing money, typically from a bank (i.e., taking on debt). The advantage to taking on debt is that doing so does not dilute the ownership stakes of the company’s existing shareholders. However, the disadvantage to debt is that the company must typically make regular interest and principal payments on the debt, which can be problematic, for example, to young and growing companies that are investing heavily in their business but are not yet generating significant cash flows.

Issuing equity, while having the disadvantage of diluting the existing shareholders, has the advantage of giving the company financial flexibility – the company can wait to pay shareholders dividends until it has achieved its growth objectives and has begun to generate profits.