Investment is the source of fresh life to a company. No matter the stage of the company, right since its very inception, investment remains the heart of business transactions. However, with investments comes greater responsibility of issuing securities that will sufficiently safeguard the interests of the investor. While issuing a particular form of security it is also to be kept in mind what is the intention of the investor behind his investment. This article aims at listing out the different types of securities that are issued in a primary market to an investor and when it is done so.
- 1 Introduction- What are securities in an investment transaction?
- 1.0.1 Types of securities that are offered
- 1.0.2 Types of shares issued
- 1.0.3 Equity Shares
- 1.0.4 Preference Shares
- 18.104.22.168 Cumulative Preference Shares
- 22.214.171.124 Non-cumulative Preference Shares
- 126.96.36.199 Convertible Preference Shares
- 188.8.131.52 Non-convertible Preference Shares
- 184.108.40.206 Redeemable Preference Shares
- 220.127.116.11 Irredeemable Preference Shares
- 18.104.22.168 Participating Preference Shares
- 22.214.171.124 Non-participating Preference Shares
- 1.1 Debentures
- 1.2 Derivatives
- 1.3 Conclusion
Introduction- What are securities in an investment transaction?
Security is a financial instrument issued to an investor against the amount invested. The security essentially aims at representing a part of ownership in the company or a relationship with a creditor. Section 2(h) of the Securities Contracts (Regulations) Act, 1956 states that securities can be issued in the form of shares, scripts, debentures, bonds or any other marketable securities in an incorporated company or other corporate body. The rights and interests charged on the security are also a part of the securities offered. This article shall aim to elucidate the types of securities offered by a company in a primary market.
Types of securities that are offered
The securities offered by a company can be briefly categorized under the following heads:
- Equity Securities: Equity securities can be further divided into equity shares and preference shares. Equity securities are not subject to repayment. Instead, the investor gets a certain percentage ownership stake represented by shares. As a return for the investment, the company shares a percentage of profit with the investor.
- Debt Securities: Debt securities are a representation of money that has been borrowed by a company (security issuer) from a creditor (security holder) which states that the debt must be repaid within a stipulated period with a fixed rate of interest. Debt securities are different from equity securities because they do not entail voting rights as is seen in the case of equity securities.
- Hybrid Securities: As the name suggests, hybrid securities entail both forms of securities mentioned above.
Shares issued in lieu of equity securities are generally of two types: equity and preference shares.
Equity shareholders enjoy voting rights and take part in the decision making processes of the company. They participate in matters such as remuneration and appointment of directors, or on important matters that need the approval of the members of the company. Equity shares are also issued with differential voting rights that essentially take place in case of financial investors who are more concerned about the returns of the company rather than running the company.
The equity shareholders are also not liable to be paid a certain fixed amount of interest. However, in cases of monetary gain, the equity shareholders share a direct percentage of the profits of the company. In this regard, it can be said that although the risk is potentially high in case of an equity shareholder, the returns are significantly higher.
The entitlements born out of a preference shareholding pattern are significantly different than in case of an equity shareholder. The shareholder gives up voting rights in exchange for a preference for a fixed amount of dividend payment and payment of dues in case of liquidity over equity shareholders.
Preference shares can be categorized into four distinct categories. They are:
The dividend paid to preference shareholders is out of the remaining free reserves of the company. In the case of cumulative preference shareholder pattern, the dividends if not paid in one financial year can be claimed in the next financial year.
Unless mentioned otherwise, preference shares issued are generally in the form of cumulative preference shares.
Non-preference shares are such that if the dividend is not paid for a financial year, the right to claim that dividend is destroyed. The dividends are not immune to a downturn in the profits garnered by a company. Investors seek non-cumulative preference shares only when there is a scope of appreciation of the capital invested. These type of shares are also generally convertible shares.
As is in the name, this type of preference shares is convertible up to a fixed rate into equity shares. Convertible preference shares are an example of a form of hybrid securities. However, it should be taken into consideration that once the shares are converted into equity shareholding, the process cannot be retracted. Hence the shareholder gives up all the benefits of a preference shareholding pattern. The issuing of convertible securities are regulated by the provisions stated in SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (SEBI ICDR)
As the name suggests, these preference shares cannot be later converted into equity shares. Since preference shares are not perpetual, they are bound to be redeemed and extinguished by the company once the amount is repaid. The Securities and Exchange Board of India (Issue and Listing of Non-Convertible Redeemable Preference Shares) Regulations, 2013 lay down the governing provisions for non-convertible preference shares.
Redeemable preference shares are issued by a company subject to the condition that the company will repay the total amount of share capital after a fixed period of time. This redemption scheme makes this type of shares very similar to debt financing and is considered to be the mode of hybrid instruments since it has both equity and debt instruments in it.
The provisions as stated under Section 55 of the Companies Act, 2013 prohibits companies limited by shares from issuing irredeemable preference shares. The conditions stipulated under the provisions of Section 55(2) holds that the company issuing the preference shares must make sure that the preference shares must be redeemable within a period not exceeding 20 years. The Companies (Share Capital and Debenture) Rules, 2014 lays down the provisions for the issue and redemption of preference shares.
These shares are irredeemable and hence do not carry the redemption factor as stated in the previous pointer. Often known as perpetual preference shares, this type of preference shares are similar to equity shares minus the rights to vote and decision-making rights. The laws regarding irredeemable preference shares are a bit tricky. According to the provisions laid down under Section 55 of the Companies Act, 2013, the maximum redemption period is twenty years. Hence, unless it is stated that the preference shares are convertible compulsorily, they remain redeemable. This means that in the event any preference share remains unconverted, it shall become redeemable after the expiry of the said term.
In case of the Banking Regulations Act, 1949, the provisions under Section 12(i) and (ii) supersedes the stipulations of Companies Act, 2013 where it says that a company limited by shares is prohibited from issuing irredeemable preference shares. However, this is only applicable to banks, as stated in the Securities and Exchange Board of India (Issue and Listing of Non-Convertible Redeemable Preference Shares) Regulations, 2013.
Participating preference shares are one of the most lucrative forms of preference shareholding pattern. Under this type of shareholding, the shareholder gets to participate in the share of profits with equity shareholders after he has already acquired the fixed debenture. In certain scenarios, the participating preference shareholder also shares into the surplus assets of the company in the instance of its winding up from the business.
What makes this shareholding pattern better than convertible shareholding is that this shareholding pattern entitles the shareholder to the benefits of both, preference shareholding and equity shareholding unlike the former where the shareholder’s transition leads to loss of one type of benefit over the other.
As in the name, non-participating shares do not have the entitlements associated with participating preference shareholding patterns.
Hence, unless expressly specified, a preference share issued is always a cumulative and non-participating preference share.
A debenture is used as a form of debt security issued by a company for a fixed rate of interest for a fixed period of time. It then becomes redeemable after the expiry of the said duration. As per the stipulations laid down under Rule 18 of Companies (Share Capital and Debentures) Rules 2014, the maximum redemption period in India is 10 years. However, the law does not bar the issuance of unsecured debentures being issued on a perpetual basis. The advantage of debentures is that it can be made convertible, i.e. the debentures can be converted to equity shares of the issuer at a specified rate.
Derivatives, as the name suggests, is an instrument where value is derived from one or multiple underlying assets. In the case of derivatives, the price of the instrument is subject to rapid fluctuation since the value of the underlying assets varies. The securities in the form of derivatives are traded in the stock exchange and fall under the ambit of Securities Contracts (Regulations) Act, 1956.
Derivatives issued by banks in the form of interest rate swaps, credit default swaps are governed by the different notifications and circulars of the Reserve Bank of India.
As is evident from the above discussion, the various types of securities issued have their own sets of merits and demerits. They strictly come into play based on the requirements of the company and the investors and the subsequent agreement reached between them. While it cannot be concluded that one type of shareholding pattern is superior to the other, investors looking for monetary gains almost always choose preference shareholding over equity shareholding. This decision comes into play partly due to the fact that equity shareholders are a part of the administration of the company, while preference shareholders share no such burden. Also, the latter promises a fixed rate of return as opposed to the first.