A company can decide to take over another one for various reasons, some of which are to eliminate competition; expand customer base; and reduce cost of production. In the absence of retained earnings, the takeover may be financed in various ways.
A public issue of equity
This amounts to the company selling shares, normally through an intermediary, to the general investing public. This is a relatively rare event except when a newly listed business is seeking a wider ownership for its shares. Once listed, companies tend not to use public issues. This is for several reasons:
• Public issues are expensive. The issue costs (legal, administrative etc.) can be very costly; 10% or more of the value of the funds raised, though there are economies of scale so large issues are proportionately cheaper.
• Setting the issue price is difficult and important. Since shares already exist in the market, there needs to be fairness with the existing shareholders. If the new shares are priced more cheaply than existing ones, the new shareholders gain an advantage at the expense of the existing ones, yet unless the new shares are no more expensive than the existing ones, investors would buy in the market, not the new shares. This would lead to a very expensive failure. A further problem arises from the fact that, administratively, it is necessary to set the issue price some days before the issue date. During the intervening period the market price could alter.
• Control of the company could pass from the existing shareholders to the new ones. Since existing shareholders have the right to be offered shares first, those shareholders can in effect, block a public issue in favor of a right issue.
A rights issue is where each existing shareholder is given the ‘right’ to take up a number of new shares which represents a proportion of the existing holding. Shareholders who do not wish to take up their rights can usually sell the right to another investor who will be able to take up the rights instead. For an established listed company right issues are much more popular for the following reasons:
i. Right issues are relatively cheap to make, perhaps less than half as expensive as a public issue.
ii. The issue price is relatively unimportant. Since all existing shareholders benefit from the cheap price in proportion to their existing shareholding, there is no disproportionate gain. The company needs to make the rights price significantly cheaper than the market price. This puts pressure on shareholders either to take up the shares or to sell them to an investor who will. Thus right issue tends not to fail, that is, the shares tend to be issued and the required cash raised.
iii. Control tends to stay with the existing shareholders.
Convertible loan stock issue
Convertibles are a mixture of loan and equity financing. They are issued as loan stocks with the right to convert them into equity shares of the same company at some pre-determined rate and date.
From the investors’ point of view, they are relatively safe in that there is a close-to guaranteed interest payment periodically and a right to convert to equity if it is beneficial to do so.
From the company’s viewpoint, they are attractive because:
a. They are cheap to issue. Loan stocks are generally cheap to issue, so they become, if all goes well, a cheap way of issuing equity
b. Loan finance is relatively cheap to service because of the tax-deductibility of interest charges
c. They are self-liquidating. Provided the holders convert, the loan liquidates itself through an equity issue, which saves the company the problem of raising the cash to replace the expiring loan stock.
The disadvantages of any type of loan financing include:
• The likely need to provide security for the loan
• The possibility that lenders will impose covenants, for example restricting the level of dividends and/or insisting on a minimum liquidity ratio