In this high-summer edition of Bookkeeping in Practice, Peter Stewart turns his attention to share capital and the often-confusing terminology around shares and shareholders. While especially useful for students preparing for the M7 exam, this article also serves as a handy refresher for any member looking to strengthen their understanding of how shares work in practice.
Firstly, the term “share” is possibly the least cryptic or confusing term in the area. It refers to the part-ownership of a company. Ownership is divided into equal parts and each of these parts is called a share.
The number of parts can be as low as oneand there is no upper limit. Although each share is an equal part of ownership, different shareholders may hold different numbers of shares so that, in total, someone may own a larger part of the company than others.
If a company has 1,000 shares, a shareholder with 250 shares therefore owns 25% of the company which entitles them to 25% of the profits and assets of the company. It’s unlikely, however, that a shareholder will claim their share of the assets; they have invested in order to make a return which will be in one of two forms: an annual ‘dividend’ or a change in the value of the business and, therefore, the value of each share.
This term refers to the person (an investor) who owns any number of shares at any point in time. Shares in all companies can be bought and sold. Larger companies might be “listed” on a stock exchange, which makes buying and selling them as straightforward as trading in almost any goods. A price, which can change at a moment’s notice, is published and anyone in the market for shares can choose to take advantage of the price as it stands.
Smaller companies tend not to have a listing on a stock exchange. This does not prevent the buying and selling of shares, it just makes it less smooth. An investor seeking to buy shares in an unlisted company would have to find a shareholder who is willing to sell some shares and, between them, they would have to negotiate a price for those shares.
At no point, does the buying and selling of shares touch the books of the company.The company keeps a register of who its shareholders are as the company mustmaintain communications with its shareholders, not least to be able to pay them their share of the profits (more to come on that in a bit).
It is different when a company issues shares. This is when the company itself sells ‘new’ shares to investors. In doing so, it raises cash (capital) with which it can make investments. Depending on who invests in these shares, existing shareholders might see their percentage holding decrease (“dilution”). If the shareholder above doesn’t take up 25% of the new shares being issued, they will see their holding decrease from that 25%.
Shares have to be issued on formation of the company butfurther shares may be issued at any time the directors require further funding for investment in the business and they feel that long-term funds are most suitable. Because of the potential of dilution of ownership, shareholders will always be asked to approve a new share issue.
The different types of shares
Moving away from the shareholders for a minute, let’s look at the classification of shares. There are two types of shares with different rights and benefits:
Ordinary shares are the most common type of share. Ordinary shareholders take on all the risks (business and financial) of the company; they have no set entitlement to a return, so if a company makes losses, they might not receive dividends (an annual payment – coming up) and, in the event of a company going into liquidation, they come last after all other creditors and investors have received any payments. However, ordinary shareholders typically have voting rights, allowing them to participate in high level decision making, supporting or modifying proposals put to them by the board of directors.
In smaller companies, the ordinary shareholders are likely to work in the company, most commonly as a director, making strategic and management plans and decisions. In large companies, however, the bulk of shareholders tend to have no involvement in the day-to-day running of the business.
Preference shares rank above ordinary shares in entitlement to profits and in the event of assets being distributed upon liquidation. Preference shareholders are rarely given voting rightsbut they will be entitled to a fixed dividend each year, as long as the company has sufficient profit to pay it.
There are three terms that relate to value(or price) when we consider shares:
Nominal value (or Parvalue) forms part of the ‘name’ of the share – hence the term.
A Share Premium arises when a company issues shares for a higher price than the nominal value. If 5,000 £1 Ordinary Shares are issued at £3 eachto raise £15,000, Ordinary Share Capital will increase by £5,000 and the extra £10,000 will be recorded as a Share Premium. A Share Premium account is an historic record and will not change.
The Share Price is the amount at which shares are traded between investors. For listed companies, the share price is set by the stock market; for unlisted companies, it is arrived at by negotiation. The share price is determined without reference to either the nominal value of the shares or the premium at which those shares were issued.Changes in share price are not recorded in the books of the company.
A company could choose to have different classes of ordinary share where the shareholders have different rights. Typically, these would be identified as “A Shares”, “B Shares” and so on. It is possible that they also have different nominal values which helps to distinguish them in the balance sheet (although there would still be a single Share Premium account).
A dividend is the distribution of profits (after tax) to shareholders.
If a company makes sufficient profit, preference shareholders will be paid a defined amount (the nominal value multiplied by a percentage rate established when the shares were issued).
The amount distributed to ordinary shareholders will be ‘proposed’ by the directors of the company based on factors including:available cash; future investment plans; the amount expected by shareholders, and the ‘signal’ of confidence given to the market. The shareholders will vote at a general meeting whether to accept the proposed dividend.
Payment of the dividend will be made some time after the year end. Therefore, the balance sheet will show a ‘provision’ for the proposed dividend.
The dividend is usually stated as a “pence per share” value. The amount is completely independent of the nominal value or issue price of the share.
If there is more than one class of ordinary share capital, there will be a dividend proposed and paid for each one.
I could go on much longer about the nature of share capital and share trading but have tried to keep it close to what you need for exams (particularly M7 and Financial Statements), while touching on some terminology you may come across when following business news stories.
