LONG TERM SOURCES OF FINANCE

Lesson I

Indian Capital and Stock Market

INTRODUCTION

Capital markets are a sub-part of the financial system. Conceptually, the financial
system includes a complex of institutions and mechanisms which affects the generation
of savings and their transfer to those who will invest. It may be said to be made of all
those channels through which savings become available for investments. The main
elements of the financial system are a variety of (i) financial
instruments/assets/securities, (ii) financial intermediaries/institutions and (iii) financial
markets.

Financial Assets

A financial asset/Instrument/security is a claim against another economic unit and is

held as a store of value and for the return that is expected. While the value of a
tangible/physical asset depends on its physical properties such as buildings, machines,
furniture vehicles and so on, a financial asset represents a claim to future cash flows in
the form of interest, dividends and so on. They are a claim on a stream of income
and/or particular assets. The entity/economic unit that offers the future cash flows is the
issuer of the financial instrument’ and the owner of the security is the investor’.

Depending upon the nature of claim/return, an instrument may be (i) debt (security)
such as bonds, debentures, term loans, (ii) equity (security) shares and (iii) hybrid
security such as preference shares and convertibles, Based on the type of issuer, the
security may be (1) direct (2) indirect and (3) derivative. The securities issued by
manufacturing companies are direct assets (e.g. shares/debentures). Indirect assets are
claims against financial intermediaries (e.g. units of mutual funds). The derivative
instruments include options and futures. The prevalence of a variety of securities to suit
the investment requirements of heterogeneous investors, offers differentiated
investment choice to them and is an important element in the maturity and
sophistication of the financial system.

Financial Intermediaries

Financial Intermediaries are institutions that channelise the savings of investors into
investments/loans. As institutional source of finance, they act as a link between the
savers and the investors, which results in institutionalisation of personal savings. Their
main function is to convert direct financial assets into indirect securities. The indirect
securities offer to the individual investor better investment alternative than the
direct/primary security by pooling which it is created, for example, units of mutual funds.
The main consideration underlying the attractiveness of indirect securities is that the
pooling of funds by the financial intermediary leads to a number of benefits to the
investors. The services/benefits that tailor indirect financial assets to the requirements
of the investors are (i) convenience, (ii) lower risk, (iii) expert management and (iv)
lower cost.

Convenience

Financial intermediaries convert direct/primary securities into a more convenient vehicle

of investment. They divide primary securities of higher denomination into indirect
securities of lower denomination. They also transform a primary security of certain
maturity into an, indirect security of a different maturity. For instance, as a result of the
redemption/repurchase facility available to unitholders of mutual funds, maturities on
units would conform more with the desires of the investors than those on primary
securities.

Lower Risk
The lower risk associated with indirect securities results from the benefits of
diversification of investments. In effect, the financial intermediaries transform the small
investors in matters of diversification into large institutional investors as the former
shares proportionate beneficiary interest in the total portfolio of the latter.

Expert Management

Indirect securities give to the investors the benefits of trained, experienced and
specialised management together with continuous supervision. In effect, financial
intermediaries place the individual investors in the same position in the matter of expert
management as large institutional investors.

Low Cost

Low cost is the benefits of investment through financial intermediaries are available to
the individual investors at relatively lower cost due to the economies of scale.

The major financial intermediaries are banks, insurance organisations, both life and
non-life/ general, mutual funds, non-banking financial companies and so on.

Financial Markets

Financial markets perform a crucial function in the financial system as facilitating

organisations. Unlike financial intermediaries, they are not a source of funds but are a
link and provide a forum in which suppliers of funds and demanders of
loans/investments can transact business directly. While the loans and investments of
financial intermediaries are made without the direct knowledge of the suppliers of funds
(i.e. investors), suppliers in the financial market know where their funds are being
lent/invested. The two key financial markets are the money market and the capital
market.

Money Market
The money market is created by a financial relationship between suppliers and
demanders of short-term funds which have maturities of one year or less. It exists
because investors (i.e. individuals, business entities, government and financial
institutions) have temporarily idle funds that they wish to place in some type of liquid
asset or short-term interest-earning instrument. At the same time, other entities/
organisations find themselves in need of seasonal/ temporary financing. The money
market brings together these suppliers and demanders of short- term liquid funds. The
broad objectives of money market are three-fold:

An equilibrating mechanism for evening out short-term surplus and

deficiencies in the financial system;

A focal point of intervention by the central bank (e.g. Reserve Bank of India)
intervention for influencing liquidity in the economy; and

A reasonable access to the users of short-term funds to meet their

requirements at realistic/ reasonable cost and temporary deployment of funds
for earning returns to the suppliers of funds.

Capital Market

The capital market is a financial relationship created by a number of institutions and

arrangements that allows suppliers and demanders of long-term funds (i.e. funds with
maturities exceeding one year) to make transactions. It is a market for long-term funds.
Included among long-term funds are securities issues of business and Government.
The backbone of the capital market is formed by the various securities exchanges that
provide a forum for equity (equity market) and debt (debt market) transactions.
Mechanisms for efficiently offering and trading securities contribute to the functioning of
capital markets which is important to the long-term growth of business. Thus, the capital
market comprises of (I) stock/security exchanges/markets (secondary markets) and (2)
new issue/primary market [initial public offering (IPO) market].

Relationship Between New Issue Market (NIM) and Stock Exchange

The industrial securities market is divided into two parts, namely, NIM and stock market.
The relationship between these parts of the market provides an insight into its
organisation. One aspect of their relationship is that they differ from each other
organisationally as well as in the nature of functions performed by them. They have
some similarities also.

Differences

The differences between NIM and stock exchanges pertain to (i) Types of securities
dealt, (ii) Nature of financing and (iii) Organisation.

New vs Old Securities

The NIM deals with new securities, that is, securities which were not previously
available and are, therefore, offered to the investing public for the first time. The market,
therefore, derives its name from the fact that it makes available a new block of
securities for public subscription. The stock market, on the other hand, is a market for
old securities which may be defined as securities which have been issued already and
granted stock exchange quotation. The stock exchanges, therefore, provide a regular
and continuous market for buying and selling of securities. The usual procedure is that
when an enterprise is in need of funds, it approaches the investing public, both
individuals and institutions, to subscribe to its issue of capital. The securities thus
floated are subsequently purchased and sold among the individual and institutional
investors. There are, in other words, two stages involved in the purchase and sale of
securities. In the first stage, the securities are acquired from the issuing companies
themselves and these are, in the second stage, purchased and sold continuously
among the investors without any involvement of the companies whose securities
constitute the stock-intrude except in the strictly limited sense of registering the transfer
of ownership of the securities. The section of the industrial securities market dealing
with the first stage is referred to as the NIM, while secondary market covers the second
stage of the dealings in securities.

Nature of Financing
Another aspect related to the separate functions of these two parts of the securities
market is the nature of their contribution to industrial financing. Since the primary market
is concerned with new securities, it provides additional funds to the issuing companies
either for starting a new enterprise or for the expansion or diversification of the existing
one and, therefore, its contribution to company financing is direct. In contrast, the
secondary markets can in no circumstance supply additional funds since the company
is not involved in the transaction. This, however, does not mean that the stock markets
have no relevance in the process of transfer of resources from savers to investors. Their
role regarding the supply of capital is indirect. The usual course in the development of
industrial enterprise seems to be that those who bar the initial burden of financing a new
enterprise, pass it on to others when the enterprise becomes well established. The
existence of secondary markets which provide, institutional facilities for the continuous
purchase and sale of securities and, to that extent, lend liquidity and marketability, play
an important part in the process.

Organisational Differences

The two parts of the market have organisational differences also. The stock exchanges
have, organisationally speaking, physical existence and are located in a particular
geographical area. The NIM is not rooted in any particular spot and has no geographical
existence. The NIM has neither any tangible form any administrative organisational set
up like that of stock exchanges, nor is it subjected to any centralised control and
administration for the consummation of its business. It is recognised only by the
services that it renders to the lenders and borrowers of capital funds at the time of any
particular operation. The precise nature of the specialised institutional facilities provided
by the NIM is described in a subsequent section.

Similarities

Nevertheless, in spite of organisational and functional differences, the NIM and the
stock exchanges are inseparably connected.

Stock Exchange Listing

One aspect of this inseparable connection between them is that the securities issued in
the NIM are invariably listed on a recognised stock exchange for dealings in them. In
India, for instance, one of the conditions to which a prospectus is to conform is that it
should contain a stipulation that the application has been made, or will be made in due
course for admitting the securities to dealings on the stock exchange. The practice of
listing of new issues on the stock market is of immense utility to the potential investors
who can be sure that should they receive an allotment of new issues, they will
subsequently be able to dispose them off any time. The absence of such facilities would
act as some sort of psychological barrier to investments in new securities. The facilities
provided by the secondary markets, therefore, encourage holdings of new securities
and, thus, widen the initial/primary market for them.

Control

The stock exchanges exercise considerable control over the organisation of new issues.
In terms of regulatory framework related to dealings in securities, the new issues of
securities which seek stock quotation/listing have to comply with statutory rules as well
as regulations framed by the stock exchanges with the object of ensuring fair dealings in
them. If the new issues do not conform to the prescribed stipulations, the stock
exchanges would refuse listing facilities to them. This requirement obviously enables
the stock exchange to exercise considerable control over the new issues market and is
indicative of close relationship between the two.

Economic Interdependence

The markets for new and old securities are, economically, an integral part of a single
market—the industrial securities market. Their mutual interdependence from the
economic point of view has two dimensions. One, the behavior of the stock exchanges
has a significant bearing on the level of activity in the NIM and, therefore, its responses
to capital issues: Activity in the new issues market and the movement in the prices of
stock exchange securities are broadly related: new Issues increase when share values
are rising and vice versa.1 This is because the two parts of the industrial securities
market are susceptible to common influences and they act and react upon each other.
The stock exchanges are usually the first to feel a change in the economic outlook and
the effect is quickly transmitted to the new issue section of the market.

The second dimension of the mutual interdependence of the two parts of the market is
that the prices of new issues are influenced by the price movements on the stock
market. The securities market represents an important case where the stock-demand-
and-supply curves, as distinguished from flow-demand-and-supply curves, exert a
dominant influence on price determination. The quantitative predominance of old
securities in the market usually ensures that it is these which set the tone of the market
as a whole and govern the prices and acceptability of the new issues. Thus, the flow of
new savings into new securities is profoundly influenced by the conditions prevailing in
the old securities market—the stock exchange.

Functions of Stock Exchanges (Secondary Markets

Stock exchanges discharge three vital functions in the orderly growth of capital
formation:

(i) Nexus between savings and investments, (ii) Market place and (iii) Continuous price
formation.

Nexus between Savings and Investment

First and foremost, they are the nexus between the savings and the investments of the
community. The savings of the community are mobilised and channelled by stock
exchanges for investment into those sectors and units which are favoured by the
community at large, on the basis of such criteria as good return, appreciation of capital,
and so on. It is the preference of investors for individual units as well as industry groups,
which is reflected in the share price, that decides the mode of investment. Stock
exchanges render this service by arranging for the preliminary distribution of new issues
of capital, offered through prospectus, as also offers for sale of existing securities, in an
orderly and systematic manner. They themselves administer the same, by ensuring that
the various requisites of listing (such as offering at least the prescribed minimum
percentage of capital to the public, keeping the subscription list open for a minimum
period of days, making provision for receiving applications at least at the prescribed
centres, allotting the shares against applications on a fair and unconditional basis) are
duly complied with Members of stock.

Exchanges also assist in the flotation of new issues by acting (i) as brokers, in which
capacity they, inter alia, try to procure subscription from investors spread all over the
country, and (ii) as underwriters. This quite often results in their being required to nurse
new issues till a time when the new ventures start making profits and reward their
shareholders by declaring reasonable dividends when their shares command premiums
in the market. Stock companies also provide a forum for trading in rights shares of
companies already listed, thereby enabling a new class of investors to take up a part of
the rights in the place of existing shareholders who renounce their rights for monetary
considerations.

Market Place

The second important function discharged by stock markets/exchanges is that they

provide a marker place for the purchase and sale of securities, thereby enabling their
free transferability through several successive stages from the original subscriber to the
neverending stream of buyers, who may be buying them today to sell them at a later
date for a variety of considerations like meeting their own needs of liquidity, shuffling
their investment portfolios to gear up for the ever changing market situations, and so on.
Since the point of aggregate sale and purchase is centralised, with a multiplicity of
buyers and sellers at any point of time, by and large, a seller has a ready purchaser and
a purchaser has a ready seller at a price which can he said to be competitive. This
guarantees saleability to one who has already invested and surety of purchase to the
other who desires to invest.

Continuous Price Formation

The third major function, closely related to the second, discharged by the stock
exchanges is the process of continuous price formation. The collective judgement of
many people operating simultaneously in the market, resulting in the emergence of a
large number of buyers and sellers at any point of time, has the effect of bringing about
changes in the levels of security prices in small graduations, thereby evening out wide
swings in prices. The ever changing demand and supply conditions result in a
continuous revaluation of assets, with today’s prices being yesterday’s prices, altered,
corrected, and adjusted, and tomorrow’s values being again today’s values altered,
corrected and adjusted. The process is an unending one. Stock exchanges thus act as
a barometer of ‘the state of health of the nations economy, by constantly measuring its
progress or otherwise. An investor can always have his eyes turned towards the stock
exchanges to know, at any point of time, the value of the investments and plan his
personal needs accordingly.

Functions of New Issues/Primary Market

The main function of NIM is to facilitate the transfer of resources from savers to
entrepreneurs seeking to establish new enterprise or to expand/diversify existing ones.
Such facilities are of crucial importance in the context of the dichotomy of funds
available for capital uses from those in whose hands they accumulate, and those by
whom they are applied to productive uses. Conceptually, the NIM should not, however,
be conceived as exclusively serving the purpose of raising finance for new capital
expenditure. In fact, the organisation and facilities of the market are also utilised for
selling concerns to the public as going concerns through the conversion of existing
proprietary enterprises or private companies into public companies. The NIM is a
complex of institutions through which funds can be obtained directly or indirectly by
those who require them from investors who have savings.

New issues can be classified in various ways. The first of new issues are by new
companies and old companies. This classification was first suggested by R.F.
Henderson. The distinction between new also called initial and old also known as
further, does not bear any relation to the age of the company. The securities issued by
companies for the first time either after the incorporation or conversion from private to
public companies are designated as initial issues, while those issued by companies
which already have stock exchange quotation, either by public issue or by rights to
existing shareholders, are referred to as further or old.

The new issues by corporate enterprise can also be classified on the basis of
companies seeking quotation, namely, new money issues and no new money issues.
The term new money issues refers to the issues of capital involving newly created
shares; no new money issues represent the sale of securities already in existence and
sold by their holders. The new money issues provide funds to enterprises for additional
capital investment. According to Merrett and others, 5 new money refers to the sum of
money equivalent to the number of newly created shares multiplied by the price per
share minus all the administrative cost associated with the issue. This money may not
be used for additional capital investment; it may be used wholly or partly to repay debt.
Henderson uses the term in a rather limited sense so that it is the net of repayment of
long-term debt and sums paid to vendors of existing securities. The differences in the
approaches by Merrett and others, on the one hand, and Henderson, on the other, arise
because of the fact that while the concern of the former is with both flow of funds into
the market as well as flow of money, Henderson was interested only in the latter.

However, two types of issues are excluded from the category of new issues. First,
bonus/ capitalisation issues which represent only book-keeping entries, and, second,
exchange issues by which shares in one company are exchanged for securities of
another.

The general function of the NIM, namely, the channelling of investible funds into
industrial enterprises, can be split from the operational stand-point, into three services
(i) Origination,(ii) Underwriting, and (iii) Distribution. The institutional set-up dealing with
these can be said to constitute the NIM organisation. In other words, the NIM facilitates
the transfer of resources by providing specialist institutional facilities to perform the
triple-service function.
Origination

The term origination refers to the work of investigation and analysis and processing of
new proposals. These two functions8 are performed by the specialist agencies which
act as the sponsors of issues. One aspect is the preliminary investigation which entails
a careful study of technical, economic, financial, and legal aspects of the issuing
companies. This is to ensure that it warrants the backing of the issue houses in the
sense of lending their name to the company and, thus, give the issue the stamp of
respectability, to satisfy themselves that the company is strongly based, has good
market prospects, is well-managed and is worthy of stock exchange quotation. In the
process of origination, the sponsoring institutions render, as a second function, some
services of an advisory nature that go to improve the quality of capital issues. These
services include advice on such aspects of capital issues as: (i) determination of the
class of security to be issued and price of the issues in the light of market conditions, (ii)
the timing and magnitude of issues, (iii) methods of Rotation, and (iv) technique of
selling, and so on. The importance of the specialised services provided by the NIM
organisation in this respect can hardly be overstressed in view of its pivotal position in
the process of flotation of capital in the NIM. On the thoroughness of investigation and
soundness of judgement of the sponsoring institutions depends, to a large extent, the
allocative efficiency of the market.

Underwriting

The origination howsoever thoroughly done, will not, by itself, guarantee the success of
an issue. To ensure success of an issue, therefore, the second specialist service—
underwriting—provided by the institutional setup of the NIM takes the form of a
guarantee that the issues would be sold by eliminating the risk arising from uncertainty
of public response. That adequate institutional arrangement for the provision of
underwriting is of crucial significance both to the issuing companies as well as the
investing public cannot be overstressed.

Distribution
Underwriting, however, is only a stopgap arrangement to guarantee the success of an
issue, in the ultimate analysis, depends on the issues being acquired by the investing
public. The sale of securities to the ultimate investors is referred to as distribution. It is a
specialist job, which can best be performed by brokers and dealers in securities, who
maintain regular and direct contact with the ultimate investors.

Thus, the NIM is a complex of institutions through which funds can be obtained by those
who require them from investors who have savings. The ability of the NIM to cope with
the growing requirements of the expanding corporate sector would depend on the
presence of specialist agencies to perform the triple-service-function of origination,
underwriting and distribution. While the nature of the services provided by an organised
NIM is the same in all developed countries,the degree of development and
specialisation of market organisation, the type of institutions found and the actual
procedures followed differ from country to country, as they are determined partly by
history and partly by the particular legal, social, political, and economic environment.

Issue Mechanism

The success of an issue depends, partly, on the issue mechanism. The methods by
which new issues are made are: (i) Public issue through prospectus, (ii) Tender/Book
building, (iii) Offer for sale (iv) Placement and (v) Rights issue.

Public Issue through Prospectus

A common method followed by corporate enterprises to raise capital through the issue
of securities is by means of a prospectus inviting subscription from the investing public.
Under this method, the issuing companies themselves offer directly to the general public
a fixed number of shares at a stated price, which in the case of new companies is
invariably the face value of the securities, and in the case of existing companies, it may
sometimes include a premium amount, if any. Another feature of public issue method is
that generally the issues are underwritten to ensure success arising out of
unsatisfactory public response.
The foundation of the public issue method is a prospectus, the minimum contents of
which are prescribed by the Companies Act, 1956. It also provides both civil and
criminal liability for any misstatement in the prospectus. Additional disclosure
requirements are also mandated by the SEBI. The contents of the prospectus, inter alia,
include: (i) Name and registered office of the issuing company; (ii) Existing and
proposed activities; (iii) Board of directors; (iv) Location of the industry; (v) Authorised,
subscribed and proposed issue of capital to public; (vi) Dates of opening and closing of
subscription list; (vii) Name of broker, underwriters, and others, from whom application
forms along with copies of prospectus can be obtained; (viii) Minimum subscription; (ix)
Names of underwriters, if any, along with a statement that in the opinion of the directors,
the resources of the underwriters are sufficient to meet the underwriting obligations; and
(x) A statement that the company will make an application to stock exchange(s) for the
permission to deal in or for a quotation of its shares and so on.

The public issue method through prospectus has the advantage that the transaction is
carried on in the full light of publicity coupled with approach to the entire investing
public. Moreover, a fixed quantity of stock has to be allotted among applicants on a non-
discriminatory basis. The issues are, thus, widely distributed and the danger of an
artificial restriction on the quantity of shares available is avoided. It would ensure that
the share ownership is widely diffused, thereby contributing to the prevention of
concentration of wealth and economic power.

A serious drawback of public issue, as a method to raise capital through the sale of
securities, is that it is a highly expensive method. The cost of flotation involves
underwriting expenses, brokerage, and other administrative expenses. The
administrative cost includes printing charges of prospectus, advertisement/publicity
charges, accountancy charges, legal charges, bank charges, stamp duty, listing fee,
registration charges, travelling expenses, filling of document charges, mortgage deed
registration fee and postage and so on). In view of the high cost involved in raising
capital, the public issue method is suitable for large issues and it cannot he availed of in
case of small issues.
Tender/Book Building Method

The essence of the tender/book building method is that the pricing of the issues is left to
the investors. The issuing company incorporates all the details of the issue proposal in
the offer document on the lines of the public issue method including the
reserve/minimum price. The investors are required to quote the number of securities
and the price at which they wish to acquire.

Offer for Sale

Another method by which securities can be issued is by means of an offer for sale.
Under this method, instead of the issuing company itself offering its shares directly to
the public, it offers through the intermediary of issue houses/merchant banks/investment
banks or firms of stockbrokers. The modus operandi of the offer of sale is akin to the
public issue method in that the prospectus with strictly prescribed minimum contents
which constitutes the foundation for the sale of securities, and a known quantity of
shares are distributed to the applicants in a nondiscriminatory manner. Moreover, the
issues are underwritten to avoid the possibility of the issue being left largely in the
hands of the issuing houses. But the mechanism adopted is different. The sale of
securities with an offer for sale method is done in two stages.

In the first stage, the issuing company sells the securities to the issuing houses or
stockbrokers at an agreed fixed price and the securities, thus acquired by the
sponsoring institutions, are resold, in the second stage, by the issuing houses to the
ultimate investors. The securities are offered to the public at a price higher than the
price at which they were acquired from the company. The difference between the sale
and the purchase price, technically called as turn, represents the remuneration of the
issuing houses. In the case of public method, the issuing houses receive a fee based
upon the size and the complications involved in supervision as they act as agents of the
issuing companies. Although this is theoretically possible, but usually the issuing
houses’ remuneration in offer for sale is the turn’ out of which they also meet subsidiary
expenses such as underwriting commission, the cost of advertisement and prospectus,
and so on, whereas these are borne by the companies themselves in the case of public
issue method.

The offer for sale method shares the advantage available to public issue method. One
additional advantage of this method is that the issuing company is saved from the cost
and trouble of selling the shares to the public. Apart from being expensive, like the
public issue method, it suffers from another serious shortcoming. The securities are sold
to the investing public usually at a premium. The margin between the amount received
by the company and the price paid by the public does not become additional funds, but
it is pocketed by the issuing houses or the existing shareholders.

Placement Method

Yet another method to float new issues of capital is the placing method defined by
London Stock Exchange as "sale by an issue house or broker to their own clients of
securities which have been previously purchased or subscribed". Under this method,
securities are acquired by the issue houses, as in offer for sale method, but instead of
being subsequently offered to the public, they are placed with the clients of the issue
houses, both individual and institutional investors. Each issue house has a list of large
private and institutional investors who are always prepared to subscribe to any
securities which are issued in this manner. Thus, the flotation of the securities involves
two stages: In the first stage, shares are acquired by the issuing houses and in the
second stage, they are made available to their investor-clients. The issue houses
usually place the securities at a higher price than the price they pay and the difference,
that is, the turn is their remuneration. Alternatively, though rarely, they may arrange the
placing in return for a fee and act merely as an agent and not principal.

Another feature of placing is that, the placing letter and the other documents, when
taken together, constitute a prospectus/offer document and the information concerning
the issue has to be published. In this method, no formal underwriting of the issue is
required as the placement itself amounts to underwriting since the issue houses agree
to place the issue with their clients. They endeavour to ensure the success of the issue
by carefully vetting the issuing company concerned and offering generous subscription
terms.

Placing of securities

Securities that are unquoted is known as private placing. The securities are usually in
small companies but these may occasionally be in large companies. When the
securities to be placed are newly quoted, the method is officially known as stock
exchange placing.

The main advantage of placing, as a method of issuing new securities, is its relative
cheapness. This is partly because, many of the items of expenses in public issue and
offer for sale methods like underwriting commission, expense relating to applications
and allotment of shares, and so on are avoided. Moreover, the stock exchange
requirements relating to contents of the prospectus and its advertisement are less
onerous in the case of placing.

Its weakness arises from the point of view of distribution of securities. As the securities
are offered only to a select group of investors, it may lead to the concentration of shares
into a few hands who may create artificial scarcity of scrips in times of hectic dealings in
such shares in the market.

The placement method is advantageous to the issuing companies but it is not favorably
received by the investing public. The method is suitable in case of small issues which
cannot bear the high expenses entailed in a public issue, and also in such issues which
are unlikely to arouse much interest among the general investing public. Thus, with the
placement method, new issues can be floated by small companies which suffer from a
financial disadvantage in the form of prohibitively high cost of capital in the case of other
methods of flotation as well as at times when conditions in the market may not be
favorable as it does not depend for its success on public response. This underscores
the relevance of this method from the viewpoint of the market.

Rights Issue
The methods discussed above can be used both by new companies as well as by
established companies. In the case of companies whose shares are already listed and
widely held, shares can be offered to the existing shareholders. This is called rights
issue. Under this method, the existing shareholders are offered the right to subscribe to
new shares in proportion to the number of shares they already hold. This offer is made
by circular to ‘existing shareholders’ only.

In India, Section 81 of the Companies Act, 1956 provides that where a company
increases its subscribed capital by the issue of new shares, either after two years of its
formation or after one year of first issue of shares whichever is earlier, these have to be
first offered to the existing shareholders with a right to renounce them in favour of a
nominee. A company can, however, dispense with this requirement by passing a special
resolution to the same effect.

Rights issues are not normally underwritten but to ensure full subscription and as a
measure of abundant precaution, a few companies have resorted to underwriting of
rights shares. The experience of these companies has been that underwriters were not
called upon to take up shares in terms of their obligations. It is, therefore, observed that
such underwriting serves little economically useful purpose in that "it represents
insurance against a risk which is (i) readily avoidable and (ii) of extremely rare
occurrence even where no special steps are taken to avoid it. The chief merit of rights
issue is that it is an inexpensive method. The usual expenses like underwriting
commission, brokerage and other administrative expenses are either non-existent or are
very small. Advertising expenses have to be incurred only for sending a letter of rights to
shareholders. The management of applications and allotment is less cumbersome
because the number is limited. As already mentioned, this method can be used only by
existing companies and the general investing public has no opportunity to participate in
the new companies. The pre-emptive right of existing shareholders may conflict with the
broader objective of wider diffusion of share-ownership.
The above discussion shows that the available methods of flotation of new issues are
suitable in different circumstances and for different types of enterprises. The issue
mechanism would vary from market to market.

HAVE YOU UNDERSTOOD?

1. Discuss the main elements of the financial system.

2. Explain briefly financial assets/instruments.

3. Describe briefly the functions of financial intermediaries.

4. Explain briefly the two key financial markets.

5. Write a brief note on the differences between the new issue market and the stock
exchanges.

6. What are the similarities between the NIM and the stock market?

7. What are the functions of the stock exchanges?

8. Briefly discuss the functions of the NIM.

9. What are the different methods of flotation of issues in the primary market?

Lesson 2

Long - Term Sources of Finance

INTRODUCTION

Long-term capital is capital with maturity exceeding one year. Long-term capital is used
to fund the acquisition of fixed assets and part of current assets. Public limited
companies meet their long-term financial requirements by issuing shares and
debentures and through borrowing and public deposits. The required fund is to be
mobilized and utilized systematically by the companies.

LEARNING Objectives

On going through this lesson, you will be conversant with:

The various sources of long term capital

The different types for long term capital instruments

Merits and demerits of equity and preference share capital

Different types of debentures and their merits and demerits.

Different modes of capital issues

SEBI Guidelines on public issues.

SECTION TITLE

Sources of Capital

Broadly speaking, a company can have two main sources of funds. Internal and
external, Internal sources refer to sources from within the company External sources
refer to outside sources.

Internal sources consist of depreciation provision, general reserve fund or free reserve
— retained earnings or the saving of the company. External sources consists of share
capital, debenture capital, loans and advances (short term loans from commercial banks
and other creditors, long term loans from finance corporations and other creditors).
Share capital is considered as ownership or equity capital whereas debentures and
loans constitute borrowed or debt capital. Raising capital through issue of shares,
debentures or bonds is known as primary capital sourcing. Otherwise it is called new
issues market.

Long-term sources of finance consist of ownership securities y shares and preference

shares) and creditor-ship securities (debentures, towing from the financing institutions
and lease finance). Short-term sources of finance consists of trade credit, short-term
loans from banks and financial institutions and public deposits.

Long-Term Capital Instruments

Corporate securities also known as company securities are said to be the documentary
media of raising capital by the joint stock companies. These are of two classes:
Ownership securities; and Creditor-ship securities.

Ownership Securities

Ownership securities consist of shares issued to the intending investors with the right to
participate in the profit and management of the company. The capital raised in this way
is called ‘owned capital’. Equity shares and securities like the irredeemable preference
shares are called ownership securities. Retained earnings also constitute owned capital.

Creditor-ship Securities

Creditor-ship securities consist of various types of debentures which are

acknowledgements of corporate debts to the respective holders with a right to receive
interest at specified rate and refund of the principal sum at the expiry of the agreed
term. Capital raised through creditor-ship securities is known as ‘borrowed capital’.
Debentures, bonds, notes, commercial papers etc. are instruments of debt or borrowed
capital.
Equity Shares

Equity shares are instruments to raise equity capital. The equity share capital is the
backbone of any company’s financial structure. Equity capital represents ownership
capital. Equity shareholders collectively own the company. They enjoy the reward of
ownership and bear the risk of ownership. The equity share capital is also termed as the
venture capital on account of the risk involved in it. The equity shareholders’ liability,
unlike the liability of the owner in a proprietary concern and the partners in a partnership
concern, is limited to their capital subscription and contribution.

Advantages of Equity Share Capital

1. Equity share capital constitutes the ‘corpus’ of the company. It is the ‘heart’ to the
business.

2. It represents permanent capital. Hence, there is no problem of refunding the

capital. It is repayable only in the event of company’s winding up and that too
only after the claims of preference shareholders have been met in full.

3. Equity share capital does not involve any fixed obligation for payment of
dividend. Payment of dividend to equity shareholders depends on the availability
of profit and the discretion of the Board of Directors.

4. Equity shares do not create any charge on the assets of the company and the
assets may be used as security for further financing.

5. Equity capital is the risk-bearing capital, unlike debt capital which is risk-
burdening.

6. Equity share capital strengthens the credit worthiness and borrowing or debt
capacity of the company. In general, other things being equal, the larger the
equity base, the higher the ability of the company to secure debt capital.
 7. Equity capital market is now expanding and the global capital market can be
accessed.

Disadvantages of Equity Shares capital

1. Cost of issue of equity shares is high, as the limited group of risk- seeking
investors need to be attracted and targeted. Equity shares attract only those
classes of investors who can take risk. Conservative and cautious investors do
not subscribe for equity issues, underwriting commission, brokerage costs and
other issue expense’ are high for equity capital, rising up issue cost.

2. The cost of servicing equity capital is generally higher than the cost of issuing
preference shares or debenture since on account of higher rise, the expectation
of the equity shareholders is also high as compared preference shares or
debentures.

3. Equity dividend is payable from post-tax earnings. Unlike interest" paid on debt
capital, dividend is not deductible as an expense from the profit for taxation
purposes. Hence cost of equity is high Sometimes, dividend tax is paid, further
rising cost of equity share capital.

4. The issuing of equity capital causes dilution of control of the equity holders.In
times of depression, dividends on equity shares reach low be which leads to
drastic fall in their market values.

5. Excessive reliance on financing through equity shares reduces the capacity of

the company to trade on equity. The excessive use of equity shares is likely to
result in over capitalization of the company.

Preference Shares

Preference shares are those which catty priority rights in regard to the payment of
dividend and return of capital and at the same time are subject to certain limitations with
regard to voting rights.
The preference shareholders are entitled to receive the fixed rate of dividend out of the
net profit of the company. Only after the payment of dividend at a fixed rate is made to
the preference shareholders, the balance of it will be used for paying dividend to
ordinary shares. The rate of dividend preference shares is mentioned in the prospectus.
Similarly in the event of liquidation the assets remaining after payment of all debts of the
company are first used for returning the capital contributed by the preference
shareholders.

Types of Preference Shares

There are many forms of preference shares. These are:

1. Cumulative preference shares

2. Non-Cumulative preference shares

3. Participating preference shares

4. Non-participating preference shares

5. Convertible preference shares

6. Non-convertible preference shares

7. Redeemable preference shares

8. Ir-redeemable preference shares

9. Cumulative convertible preference shares

Merits of Preference shares

1. The preference shares have the merits of equity shares without their limitations.

2. Issue of preference shares does not create any charge against the assets of the
company.
 3. The promoters of the company can retain control over the company by issuing
preference shares, since the preference shareholders have only limited voting
rights.

4. In the case of redeemable preference shares, there is the advantage that the
amount can be repaid as soon as the company is in possession of funds flowing
out of profits.

5. Preference shares are entitled to a fixed rate of dividend and the company may
declare higher rates of dividend for the equity shareholders by trading on equity
and enhance market value.

6. If the assets of the company are not of high value, debenture holders will not
accept them as collateral securities. Hence the company prefers to tap market
with preference shares.

7. The public deposit of companies in excess of the maximum limit stipulated by the
Reserve Bank can be liquidated by issuing preference shares.

8. Preference shares are particularly useful for those investors who want higher rate
of return with comparatively lower risk.

9. Preference shares add to the equity base of the company and they strengthen
the financial position of it. Additional equity base increases the ability of the
company to borrow in future.

10. Preference shares have variety and diversity, unlike equity shares; Companies
thus have flexibility in choice.

Demerits of Preference Shares

1. Usually preference shares carry higher rate of dividend than the rate of interest
on debentures.
 2. Compared to debt capital, preference share capital is a very expensive source of
financing because the dividend paid to preference shareholders is not, unlike
debt interest, a tax-deductible expense.

3. In the case of cumulative preference shares, arrears of dividend accumulate. It is

a permanent burden on the profits of the company.

4. From the investor’s point of view, preference shares may be disadvantageous

because they do not carry voting rights. Their interest may be damaged by equity
shareholders in whose hands the control is vested.

5. Preference shares have to attraction. Not even 1% of total corporate capital is

raised in this form.

6. Instead of combining the benefits of equity and debt, preference share capital,
perhaps combines the benefits of equity and debt.

Debentures

A debenture is a document issued by a company as an evidence of a debt due from the

company with or without a charge on the assets of the company. It is an
acknowledgement of the company’s indebtedness to its debenture-holders. Debentures
are instruments for raising long-term debt capital. Debenture holders are the creditors of
the company.

In India, according to the Companies Act, 1956, the term debenture includes "debenture
stock, bonds and any other securities of company whether constituting a charge on the
assets of the company or not"

Debenture-holders are entitled to periodical payment of interest agreed rate. They are
also entitled to redemption of their capital as per the terms. No voting rights are given to
debenture-holders. Under section 117 of the companies Act, 1956, debentures with
voting rights cannot be issued. Usually debentures are secured by charge on or
mortgage of the assets of the company.

Types of debentures

Debentures can be various types. They are:

1. Registered debentures

2. Bearer debentures or unregistered debentures

3. Secured debentures

4. Unsecured debentures

5. Redeemable debentures

6. Irredeemable debentures

7. Fully convertible debentures

8. Non-convertible debentures

9. Partly convertible debentures

10. Equitable debentures

11. Legal debentures

12. Preferred debentures

13. Fixed rate debentures

14. Floating rate debentures

15. Zero coupon debentures

 16. Foreign currency convertible debentures

Registered debentures: Registered debentures are recorded in a register of

debenture-holders with full details about the number, value and types of debentures
held by the debenture-holders. The payment of interest and repayment of capital is
made to the debenture-holders whose names are entered duly in the register of
debenture-holders. Registered debentures are not negotiable. Transfer of ownership of
these types of debentures cannot be valid unless the regular instrument of transfer is
sanctioned by the Directors. Registered debentures are not transferable by mere
delivery.

Bearer or Unregistered debentures: The debentures which are payable to the bearer
are called bearer debentures. The names of the debenture-holders are not recorded in
the register of debenture-holders. Bearer debentures are negotiable. They are
transferable by mere delivery and registration of transfer is not necessary.

Secured debentures: The debentures which are secured by a mortgage or change on

the whole or a part of the assets of the company are called secure debentures.

Unsecured debentures: Unsecured debentures are those, which do not have charge
on the assets of the company.

Redeemable debentures: The debentures which are repayable after a certain period
are called redeemable debentures. Redeemable debentures may be bullet repayment
debentures (i.e. one time be payment) or periodic repayment debentures.

Irredeemable debentures: The debentures which are not repayable during lifetime of
the company are called irredeemable debentures. They are al known as perpetual
debentures. Irredeemable debentures can be redeemed in the event of the company’s
winding up.

Fully convertible debentures: Convertible debentures can be converted into equity

shares of the company as per the terms of their issue. Convertible debenture-holders
get an opportunity to become shareholders and to take part the company management
at a later stage. Convertibility adds a ‘sweetner’ to debentures and enhances their
appeal to risk seeking investors.

Non–convertible debentures: Non-convertible debentures are not convertible They

remain as debt capital instruments.

Partly convertible debentures: Partly convertible debentures appeal to investors who

want the benefits of convertibility and non-convertibility in one instrument.

Equitable debentures: Equitable debentures are those which are secured by deposit of
title deeds of the property with a memorandum in writing to create a charge.

Legal Debentures: Legal debentures are those in which the legal ownership of property
of the corporation is transferred by a deed to the debenture holders, security for the
loans.

Preferred debentures: Preferred debentures are those which are paid first in the L time
of winding up of the company. The debentures have priority over other debentures

Fixed rate debentures: Fixed rate debentures carry a fixed rate of interest Now a days
this class is not desired by both investors and issuing institutions.

Floating rate debentures: Floating rate debentures carry floating interest rate coupons.
The rates float over some benchmark rates like bank rate, LIBOR etc.

Zero-coupon debentures: Zero-coupon debentures are merest coupons. Interest on

these is paid on maturity called as deep-discount debentures.

Foreign Currency convertible debentures: Foreign currency convertible debentures

are issued in overseas market in the currency of the country where the flotation takes
place. Later these are converted into equity, either GDR. ADR or plain equity.

Merits of debentures
 1. Debentures provide funds to the company for a long period without diluting its
control, since debenture holders are not entitled to vote.

2. Interest paid to debenture-holders is a charge on income of the company and is

deductible from computable income for income tax purpose whereas dividends
paid on shares are regarded as income and are liable to corporate income tax.
The post-tax cost of debt is thus lowered.

3. Debentures provide funds to the company for a specific period. Hence, the
company can appropriately adjust its financial plan to suit its requirements.

4. Since debentures are generally issued on redeemable basis, the company can
avoid over-capitalisation by refunding the debt when the financial needs are no
longer felt.

5. In a period of rising prices, debenture issue is advantageous. The burden of

servicing debentures, which entail a fixed monetary commitment for interest and
principal repayment, decreases in real terms as the price level increases.

6. Debentures enable company to take advantage of trading on equity and thus pay
to the equity shareholders a dividend at a rate higher than overall return on
investment.

7. Debentures are suitable to the investors who are cautious and who particularly
prefer a stable rate of return with no risk. Even institutional investors prefer
debentures for this reason.

Demerits of Debentures

1. Debenture interest and capital repayment are obligatory payments. Failure to

meet these payment jeopardizes the solvency of the firm.
 2. In the case of debentures, interest has to be paid to the debenture holders
irrespective of the fact whether the company earns profit or not. It becomes a
great burden on the finances of the company.

3. Debenture financing enhances the financial risk associated with the firm. This
may increase the cost of equity capital.

4. When assets of the company get tagged to the debenture holders the result is
that the credit rating of the company in the market comes down and financial
institutions and banks refuse loans to that company.

5. Debentures are particularly not suitable for companies whose earnings fluctuate
considerably. In case of such company raising funds through debentures, may
lead to considerable fluctuations in the rate of dividend payable to the equity
shareholders.

Financing Through Equity Shares and Debentures Comparison

A company may prefer equity finance (i) if long gestation period is involved, (ii) if equity
is preferred by the market forces, (iii) if financial risk perception is high, (iv) if debt
capacity is low and (v) dilution of control isn’t a problem or does not rise.

A company may prefer debenture financing compared to equity shares financing for the
following reasons:

i. Generally the debenture-holders cannot interfere in the management of the

company, since they do not have voting rights.

ii. Interest on debentures is allowed as a business expense and it is tax- deductible.

iii. Debenture financing is cheaper since the rate of interest payable on it is lower
than the dividend rate of preference shares.
 iv. Debentures can be redeemed in case the company does not need the funds
raised through this source. This is done by placing call option in the debentures.

v. Generally a company cannot buy its own shares but it can buy its own
debentures.

vi. Debentures offer variety and in dull market conditions only debentures help
gaining access to capital market.

Convertible Issues

A convertible issue is a bond or a share of preferred stock that can be converted at the
option of the holder into common stock of the same company. Once converted into
common stock, the stock cannot be estranged again for bonds or preferred stock. Issue
of convertible preference shares and convertible debentures are called convertible
issues. The convertible preference shares and convertible debentures are converted
into equity shares. The ratio of exchange between the convertible issues and the equity
shares can be stated in terms of either a conversion price or a conversion ratio.

Significance of convertible issues:

The convertible security provides the investor with a fixed return from a bond
(debenture) or with a specified dividend from preferred stock (preference shares). In
addition, the investor gets an option to convert the security (convertible debentures or
preference shares) into equity shares and thereby participates in the possibility of
capital gains associated with, being a residual claimant of the company. At the time of
issue, the convertible security will be priced higher than its conversion value. The
difference between the issue price and the conversion value is known as conversion
premium. The convertible facility provides a measure of flexibility to the capital structure
of the company to company which wants a debt capital to start with, but market wants
equity. So, convertible issues add sweeteners to sell debt securities to the market which
want equity issues.
Convertible preference shares: The preference shares which carry the right of
conversion into equity shares within a specified period, are called convertible preference
shares. The issue of convertible preference shares must be duly authorized by the
articles of association of the company.

Convertible debentures: Convertible debentures provide an option to their holders to

convert them into equity shares during a specified period at a particular price. The
convertible debentures are not likely to have a good investment appeal, as the rate of
interest for convertible debentures is lesser than the non-convertible debentures.
Convertible debentures help a company to sell future issue of equity shares at a price
higher than the price at which the company’s equity shares may be selling when the
convertible, debentures are issue. By convertible debentures, a company gets relatively
cheaper financial resource for business growth. Debenture interest constitutes tax
deductible expenses. So, till the debentures are converted, the company gets a tax
advantage. From the investors’ point of view, convertible debentures prove an ideal
combination of high yield, low risk and potential capital appreciation.

Different Modes of Capital Issues

Capital instruments, namely, shares and debentures can be issued to the market by
adopting any of the four modes: Public issues, Private placement, Rights issues and
Bonus issues. Let us briefly explain these different modes of issues.

Public Issues

Only public limited companies can adopt this issue when it wants to raise capital from
the general public. The company has to issue a prospectus as per requirements of the
corporate laws in force inviting the public to subscribe to the securities issued, may be
equity shares, preference shares or debentures/bonds. A private company cannot adopt
this route to raise capital. The prospectus shall give an account of the prospects of
investment in the company. Convinced public apply to the company for specified
number of shares/debentures paying the application money, i.e., money payable at the
time of application for the shares/debentures usually 20 to 30% of the issue price of the
shares/debentures. A company must receive subscription for at least 95% of the
shares/bonds offered within the specified days. Otherwise, the issue has to be
scrapped. If the public applies for more than the number of shares/debentures offered,
the situation is called over subscription. In under subscription public subscribes for less
number of shares/debentures offered by the company. For good companies coupled
with better market conditions, over —subscription results. Prior to issue of
shares/debentures and until the subscription list is open, the company goes on
promoting the issue. In the western countries such kind of promoting the issue is called
‘road-show’. When there is over-subscription a part of the excess subscription, usually
upto 15% of the offer, can be retained and allotment proceeded with. This is called as
green-shoe option.

When there is over-subscription, pro-rata allotment (proportionate basis allotment, i.e.,

say when there is 200% subscription, for every 200 share applied 100 shares allotted)
may be adopted. Alternatively, pro-rata allotment for some applicants, fill scale allotment
for some applicants and nil allotment for rest of applicants can also be followed. Usually
the company co-opts authorities from stock-exchange where listing is done, from
securities regulatory bodies (SEI3J in Indian, SEC in USA and so on) etc. in finalizing
mode of allotment.

Public issues enable broad-based share-holding. General public’s savings directed into
corporate investment. Economy, company and individual investors benefit. The
company management does not face the challenge of dilution of control over the affairs
of the company. And good price for the share’ and competitive interest rate on
debentures are quite possible.

Right Shares

Whenever an existing company wants to issue new equity shares, the existing
shareholders will be potential buyers of these shares. Gentrally the Articles or
Memorandum of Association of the Company gives the right to existing shareholders to
participate in the new equity issues of the company.

This right is known as ‘pre-emptive right’ and such offered shares are called ‘Right
shares’ or ‘Right issue’.

A right issue involves selling securities in the primary market by issuing rights to the
existing shareholders. When a company issues additional share capital, it has to be
offered in the first instance to the existing shareholders on a pro-rata basis. This is
required in India under section 81 of the Companies Act, 1956. However, the
shareholders may by a special resolution forfeit this right, partially or fully, to enable the
company to issue additional capital to public.

Under section 81 of the Companies Act 1956, where at any time after the expiry of two
years from the formation of a company, or at any time after the expiry of one year from
the allotment of shares being made for the first lime after its formation, whichever is
earlier, it is proposed to increase the subscribed capital of the company by allotment of
further shares, then such further shares shall be offered to the persons who, at the date
of the offer, are holders of the equity shares of the company, in proportion as nearly as
circumstances admit, to the capital paid on those shares at that date. Thus the existing
shareholders have a pre-emptive right to subscribe to the new issues made by a
company. This right has at its root in the doctrine that each shareholder is entitled to
participate in any further issue of capital by the company equally, so that his interest in
the company is not diluted.

Significance of rights issue

1. The number of rights that a shareholder gets is equal to the number of shares
held by him.

2. The number rights required to subscribe to an additional share is determined by

the issuing company.
 3. Rights are negotiable. The holder of rights can sell them fully or partially.

4. Rights can be exercised only during a fixed period which is usually less than
thirty days.

5. The price of rights issues is generally quite lower than market price and that a
capital gain is quite certain for the share holders.

6. Rights issue gives the existing shareholders an opportunity for the protection of
their pro-rata share in the earning and surplus of the company.

7. There is more certainty of the shares being sold to the existing shareholders. If a
rights issue is successful it is equal to favourable image and evaluation of the
company’s goodwill in the minds of the existing shareholders.

Bonus Issues

Bonus issues are capital issues by companies to existing shareholders whereby no

fresh capital is raised but capitalization of accumulated earnings is done. The shares
capital increases, but accumulated earnings fall. A company shall, while issuing bonus
shares, ensure the following:

1. The bonus issue is made out of free reserves built out of the genuine profits and
shares premium collected in cash only.

2. Reserves created by revaluation of fixed assets are not capitalized

3. The development rebate reserves or the investment allowance reserve is

considered as free reserve for the purpose of calculation of residual reserves
only.

4. All contingent liabilities disclosed in the audited accounts which have bearing on
the net profits, shall be taken into account in the calculation of the residual
reserve.
5. The residual reserves after the proposed capitalisation shall be at least 40 per
cent of the increased paid up capital.

6. 30 percent of the average profits before tax of the company for the previous three
years should yield a rate of dividend on the exp capital base of the company at
10 percent.

7. The capital reserves appearing in the balance sheet of the company as a result
of revaluation of assets or without accrual of cash resources are capitalized nor
taken into account in the computation of the residual reserves of 40 percent for
the purpose of bonus issues.

8. The declaration of bonus issue, in lieu of dividend is not made.

9. The bonus issue is not made unless the partly paid shares, if any existing, are
made fully paid-up.

10. The company — a) has not defaulted in payment of interest or principal in

respect of fixed deposits and interest on existing debentures or principal on
redemption thereof and (b) has sufficient reason to believe that it has not
defaulted in respect of the payment of statutory dues of the employees such as
contribution to provident fund, gratuity or bonus.

11. A company which announces its bonus issue after the approval of the board of
directors must implement the proposals within a period of six months from the
date of such approval and shall not have the option of changing the decision.

12. There should be a provision in the Articles of Association of the Company for
capitalisation of reserves, etc. and if not the company shall pass a resolution at
its general body meeting making decisions in the Articles of Association for
capitalisation.
 13. Consequent to the issue of bonus shares if the subscribed and paid-up capital
exceed the authorized share capital, a resolution shall be passed by the
company at its general body meeting for increasing the authorized capital.

14. The company shall get a resolution passed at its generating for bonus issue and
in the said resolution the management’s intention regarding the rate of dividend
to be declared in the year immediately after the bonus issue should be indicated.

15. No bonus shall be made which will dilute the value or rights of the holders of
debentures, convertible fully or partly.

Sebi General Guidelines for Public Issues

1. Subscription list for public issues should be kept open for at least 3 working days
and disclosed in the prospectus.

2. Rights issues shall not be kept open for more than 60 days.

3. The quantum of issue, whether through a right or public issue, shall not exceed
the amount specified in the prospectus/letter of offer. No retention of over
subscription is permissible under any circumstances, except the special case of
exercise of green-shoe option.

4. Within 45 days of the closures of an issue a report in a prescribed form with

certificate from the chartered accountant should be forwarded to SEBI to the lead
managers.

5. The gap between the closure dates of various issues eg., Rights and Indian
public should not exceed 30 days.

6. SEBI will have right to prescribe further guidelines for modifying the existing
norms to bring about adequate investor protection, enhance the quality of
disclosures and to bring about transparency in the primary market.
 7. SEBI shall have right to issue necessary clarification to these guidelines to
remove any difficulty in its implementation.

8. Any violation of the guidelines by the issuers/intermediaries will be punishable by

prosecution by SEBI under the SEBI Act

9. The provisions in the Companies Act, 1956 and other applicable laws shall be
complied in connection with the issue of shares and debentures.

Have you understood?

1. Discuss the sources of long-term finance of a company.

2. Critically evaluate equity shares a source of finance both the point of (i) the
company and (ii) investing public.

3. Discuss the features of preference shares and evaluate preference share capital
from the company’s point of view.

4. What are right shares? Explain the significance of the same from the company’s
and investors’ view point.

5. Define ‘debenture’ and bring out its salient features as an instrument of corporate
financing.

6. Explain the different types of debentures that may be issued by a company.

7. What are the advantages and disadvantages of debenture finance to a

company?

8. List out the SEBI guidelines for issuing bonus shares.

Lesson 3
 Lending Procedures of the Term Lending Financial
Institutions

INTRODUCTION

Under this head we shall see the lending procedure practiced by long-term finance

Learning Objectives

After reading this lesson, you will be conversant with:

The different types of appraisal used by term lending institution for financing
The conditions for financial assistance
The various schemes of assistance of financial institutions
The concept, merits and demerits of public deposits
The regulations of RBI regarding public deposits.

SECTION TITLE

Essential Requirements:

The essential requirements insisted upon by the financial institutions before taking up a
request for financial assistance for consideration are:

1. The applicant concerned include the following should have obtained industrial
license or should have made some kind of commitment, where necessary

2. The applicant should have obtained/applied for permission of the Securities and
Exchange Board of India to issue capital, wherever necessary

3. The applicant should have obtained the approval of the Government regarding
the terms of technical and/or financial collaboration agreement, if any.
 4. The applicant should have a clearance from the Capital Goods Committee in
respect of the machinery proposed to be imported

5. The applicant should have selected a site for the location of the factory and has
prepared a detailed ‘project report’.

After the receipt of the filled up application in triplicate in the case of non-corporate units
and quadruplicate in the case of corporate bodies, the project is appraised by a team of
technical, financial and economic officers of the Corporation from several angles —
technical, financial, economic, managerial and social.

Appraisal by Financial Institution:

1.Technical Appraisal

The technical appraisal of the project involves a critical analysis of the following:

1. Feasibility of the selected technical project and its suitability in Indian conditions.

2. Location of the project in relation to the sources and availability of inputs — raw
materials, water, power, transport, skilled and unskilled labour and in relation to
the market to be served by the product/service.

3. Adequacy of the plant and machinery and their specifications

4. Adequacy of the plant layout

5. Arrangements for securing technical know-how, if necessary

6. Availability of skilled and unskilled labour and arrangements for training for the
labourers.

7. Provision for the disposal of factory effluents and utilisation of byproducts if any.

8. Whether the process proposed for selection is technically sound up-to-date etc.
Another important feature of technical appraisal relates to the technology to be adopted
for the project. In case of new technical processes adopted from abroad, attention is to
be paid to the terms and conditions.

2.Economic Appraisal

The economic appraisal of a project involves:

1. Consideration of natural and industrial property of the project and contribution to

the national economy of the country in terms of contribution to GDP, down stream
and upstream projects.

2. Savings in foreign exchange or prospects of exports.

3. Employment potential, direct and indirect

4. A critical study of the existing and future demand for the products proposed to be
manufactured, the licensed and installed capacity, the level of competition etc.

5. Scrutiny of the project in relation to the import and export policies of the
Government and various other factors like regulatory controls, if any, in regard to
production, prices and raw materials.

3.Financial Appraisal

Financial appraisal of the existing concern deals with an analysis of its working results,
balance sheets and cash flow for the past years/projected future years and an
examination of the following aspects in all cases.

1. Estimated cost of the project

2. Financial plan with reference to capital structure, promoter’s contribution, debt-

equity ratio and the availability of other resources.
 3. Crucial examination of the investments made outside the business and
justification therefore.

4. Projections of cash flow, both during the construction and the operation periods.

5. Projects break-even level of operation and time required to reach that level of
operation.

6. Estimation of future profitability in the light of competition and product service

obsolescence.

7. Internal rate of return, debt-service coverage and projected dividends on share

capital, payback period, abandonment value at the end of different levels of
milestones or years of operation.

4.Managerial Appraisal

The confidence of the lending institution in the repayment prospects of a loan is largely
conditioned by its opinion of the borrowing unit’s management. Therefore, it has been
remarked that appraisal of management is the touch stone of term credit analysis.
Where the technical competence, administrative ability, integrity and resourcefulness of
the management are well established, the loan application gets the most favourable
consideration. The expertise, experience and earnestness of the management tells in
the efficiency, effectiveness and excellence of the project.

5.Social Appraisal

The social objectives of the project are considered keeping in view the interest of the
general public. The projects, which provide large employment opportunities and
canalize the income of the agricultural sector for productive use, projects located in
totally less developed areas and projects that stimulated small scale industries are
considered to serve the society well. The social benefits are more. The social cost of
pollution consumption of scarce resources, etc. is also to be weighed.
Conditions for Assistance from Financial Institutions

Different financial institutions stipulate different kinds of conditions depending on the

nature of the project, the borrower etc. The main conditions of a term loan are as
follows:

1. The borrower (applicant) has to obtain all relevant Government clearances such
as licensing, capital goods clearance for imported machines, import license,
clearance from pollution control board, etc.

2. For consortium loan, the borrower has to satisfy all the institutions participating in
lending

3. Concurrence of the financial institution is necessary for repayment of any existing

loan or long-term liabilities.

4. The term loan agreement may stipulate the debt-equity ratio to be followed by the
company.

5. As long as the loan is outstanding, the declaration of dividend is made subject to

the institution’s approval.

6. The term lending institution reserves the right to nominate one or more directors
in the management of the company.

7. Once the loan agreement is signed, any major commercial agreements such as
orders for equipment, consultancy, collaboration agreement, selling agency
agreement etc. and further expansion need the concurrence of the term lending
institution.

8. The borrower is not permitted to create any additional charge on the assets
without the knowledge of the financial institutions.
 9. The financial institutions may appoint suitable personnel in the areas of
marketing, research and development, depending upon the nature of the project.

10. The promoters cannot dispose their shareholders without the consent of the
lending institutions. This is stipulated for keeping the promoters involved as long
as the institutions are involved in the business.

Puplic Deposits

Deposits with companies have come into prominence in r cent years. Of these the more
important one are the deposits accepted by trading and manufacturing companies. The
Indian Central Banking Enquiry Committee in 1931 recognized the importance of public
deposits in the financing of cotton textile industry in India in general and at Ahmedabad
in particular. The growth of public deposits has been considerable. From the company’s
point of view, public deposits are a major source of finance to meet the working capital
needs. Due to the credit squeeze imposed by the Research Bank of India on bank loans
the corporate sector during 1970s 1980s and also due to the recommendations of the
Tandon Committee, restricting credit, many companies were not getting as much money
in the 1980s as they are used to getting in the past, from the banks. So, public deposits
came handy as working capital funds for the businesses. While to the depositor the rate
offered is higher than that offered by banks, the cost of deposits to the company is less
than the cost of borrowings from bank. Moreover, the availability and volume of bank
credit are restricted by considerations of margin, security offered, periodical submission
of statements etc. The credit available to companies through public deposits is not
affected by such consideration. There is no problem of margin or security. Since, the
fixed deposits from the public are unsecured, the borrowing company need not
mortgage or hypothecate any of its assets to raise loans in this form. These deposits
are available for comparatively longer terms than bank credit.

Merits of Public Deposits

The merits of public deposits are as follows:

 1. There is no need of creation of any charge against any of the assets of the
company for raising funds through public deposits.

2. The company can get advantage of trading on equity since the rate of interest
and the period for which the public deposits have been accepted are fixed.

3. Public deposit is a less costly method for raising short-term as well as medium
term funds required by the companies, because of less restrictive covenants
governing this as against bank credits.

4. No questions are asked about the uses of public deposits.

5. Tax leverage is available as interest on public deposits is a charge on revenue.

Demerits of Public Deposits

The main demerits of the public deposits are as follows:

i. This mode of financing, sometimes, puts the company into serious financial
difficulties. Even a slight rumour about the inefficiency of the company may result
in a rush of the public to the company for getting premature payments of the
deposits made by them.

ii. Easy availability of fund encourages lavish spending.

iii. Public deposits are unsecured deposits and in the event of a failure of the
company, depositors have no assurance of getting their money back.

RBI Regulations for Public Deposit

The RBI regulation of public deposits has six main aspects:

i. There is a ceiling on the quantum of deposits in terms of paid-up capital and

reserves by the company because undue accumulation of short-term liabilities in
the form of deposits can lead a company into financial difficulties. In the
 beginning the definition of deposits was quite narrow and excluded unsecured
loans accepted from the public and guaranteed by the directors. Now the term
deposit covers "an money received by a non-banking company by way of deposit
or loan or in any other form but excludes money raised by way of share capital or
contributed as capital by proprietors".

ii. The second aspect of the Reserve Bank’s regulation is the limit on the period of
such deposit. Formerly, in order to avoid direct competition with short-term public
deposits, companies were prohibited from accepting deposits for a period of less
than 12 months. But the 1973 amendment reduced the period to less than 6
months. The short-term deposit is now pegged down to 10 per cent of the
garagate of the paid-up capital and free reserves of the company while secured
and unsecured deposits shall not exceed 15 per cent and 25 per cent,
respectively, of the paid-up capital and free reserves.

iii. The Reserve Bank has made obligatory on the part of the companies accepting
deposits to regularly file the returns, giving detailed information about them, their
repayment, etc. so that the Reserve Bank can verify whether the companies
adhere to the restrictions. However such statements are not filed and the
Reserve Bank’s action to prevent a defaulting company from accepting any
deposit fails to afford any protection to the existing depositors.

iv. The Reserve Bank has stipulated that while issuing newspaper advertisements
(or even the application forms) soliciting such deposits, certain specified
information regarding the financial position and the working of the company must
accompany. This clause is often mis-ued as much advertisement often carried
words like "as per Reserve Bank directive", thereby giving a wrong impression
that these deposits are actually governed by the Reserve Bank. Now such
advertisements would be illegal and attract penal provision prescribed in this
behalf. Similarly, the catalogues and handouts issued by brokers stating that the
companies mentioned therein had complied with Reserve Bank directives would
also attract the penal provision.
 v. The Reserve Bank has entrusted the auditors of the companies with additional
responsibilities of reporting to it that the provision under the Act has been strictly
followed by the company.

vi. The Reserve Bank has issued a broad "RBI Directives on Company Deposit in
order to clarify its role in protecting the depositors. The bank has reiterated that
the deposits or loans are fully protected or are absolutely safe merely because
the companies claimed to have complied with the RBI directives and that they
should not presume that the Reserve Bank can come to their rescue in the event
of failure of a company to meet its obligations.

Have you understood?

1. What do you mean by Public Deposits? Explain their merits and demerits.

2. Explain the types of appraisal to be made in sanctioning project finance.

Lesson 4

Venture capital Financing

INTRODUCTION

In present day economy, finance is defined as the provision of money at the time when
it is required. Finance is required for all types of project and non-profit organizations, to
carry out their regular activities to achieve their objectives. Hence, it is considered as
lifeblood of economic activities. The success of any organization mainly depends on
how well financial resources are being used.

The financial services in India have undergone drastic changes in the last 50 years. In
the early 60s both primary and secondary market were functioning on traditional basis
and were inactive and unorganised. Later FERA Act, 1973, Nationalization of
commercial bank, establishment of IDBI have contributed greatly to the growth of
primary and secondary markets. From 1970 on wards an uninterrupted rise in the
industrial, agricultural and service sector growth was found. The same trend continued
even in the 80s. This led to the introduction of different types of financial instruments in
the market. But during the 90s the country faced severe balance of payments crisis,
high inflationary pressures and set back in industrial and finance sector. In the year
1991, Sri P.V. Narasimha Rao’s government with a view to bring inflation under control
and to restore normalcy. In the economy introduced the new industrial policy was
introduced.

Liberalization in industrial licensing, foreign investment, foreign technology agreements,

disinvestment of public sector units and MRTP Act amendments were introduced. The
new import and export policy brought series of changes in the economic environment.
All these attracted the financial sector. Both primary and secondary markets started
functioning as per the requirements of the market. New financial products were
introduced. Technology in banks and customer service have improved. Competitive
financial market was created focusing on needs of customers. This resulted in the
witnessing of new financial instruments in the market Viz., Leasing, Hire-purchase
Factoring, Forfeiting, Global Depository Receipts, Venture capital etc.,

Learning objectives

On going through this lesson, you will be conversant with

Definition and meaning of venture capital

Characteristic features of venture fund

Venture capital investment process

Stages of financing
 Types of organizations

Venture capital financing in India

Guidelines on venture funds capital

Present scenario of venture capital financing

The new financial instrument ‘Venture Capital’ is discussed in detail.

SECTION TITLE

Definition

Venture Capital

It is defined as long-term funds in equity or semi-equity form to finance hi-tech projects

involving high risk and yet having strong potential of high profitability.

The term ‘Venture Capital’ refers to capital investment made in a business or industrial
enterprise, which carries elements of risk and insecurity and the probability of business
hazards. Capital investment may assume the form of either equity or debt or both as a
derivative instrument, The risk associated with the enterprise could be so high as to
entail total loss or be so insignificant as to lead high gains. Generally, the investment is
made in the form of equity with the prime objective being capital gains as the business
prospers. Equity investment enables the investor to the investment into cash when
required.

Meaning

Venture Capital means many things to many people Jane Koloski Morris, editor of the
well known industry publication, Venture Economics, defines Venture capital as
‘providing seed, start-up and first stage financing’ and also funding the expansion of
companies that have already demonstrated their business potential but do not yet have
access to the public securities market or to credit oriented institutional funding sources
Venture capital also provides management in leveraged buy out financing".

The European venture capital association describes it as risk finance for entrepreneurial
growth oriented companies. It is investment for the medium or long-term seeking to
maximize medium or long-term return for both parties. It is a partnership with the
entrepreneur in which the investor can add value to the company because of his
knowledge experience and contract base.

Steven James Lee, defines it as actual or potential equity investments in companies

through the purchase of stock, warrants, options or convertible securities. Venture
capital is a long-term investment discipline that often requires the venture capitalist to
wait five or more years before realising a significant return on the capital resource.

The 1995 Finance Bill, defines Venture capital as long-term equity investment in novel
technology, based projects which display potential for significant growth and financial
returns. Hence, venture capital implies an investment in the form of equity for high risk
projects with the expectation of higher returns. The investment is made through the
private placement with the expectation of risk of total loss or huge returris. Risk is
associated with such capital investment and as such it is termed as venture capital.
High technology industry is more attractive to venture capital because of high returns.
The main object of investing equity is to get high capital profits at saturation stage.

Characteristic Features

· Investments are made in equity in high tech. Industry and wait for 5- 7 years
to reap the benefit of capital gains.

· Investments are made in innovative projects with new technology with a view
to commercialise the know how through new products\services
 · The claim over the management is decided on the basis of proportion to
investments.

· Venture capital investor does not interfere in the day-to-day business affairs
but closely watch the performance of the business unit.

· Venture capital funds need not be repaid in the course of business units, but
they are realised through exist route, (stock exchange).

Venture Capital Investment Process

Financing of a High tech., project under venture capital has following steps. They are:

1. Establishment of contact between the entrepreneur and the venture capitalist:

The Prospective entrepreneur, with his know how prepares a project report establishing
there in the possibility of marketing a commercial product. This can be done with the
help of auditor, professional or a merchant banker. The business consists of five
important feasibility reports namely, Technical, Financial, Managerial, Marketing and
Socio-economic feasibility. The formal application in duplicate will be submitted to
venture capital investor.

2. Preliminary Evaluation: After the preliminary evaluation of the report is completed,

venture capital investor normally discusses the investment plan for the project with the
banker. During this stage close net work is expected from the management team, to
implement the project.

3. Detailed Approval: In addition to the close discussion with the management team, a
detailed appraléal of project is undertaken. Techno-economic feasibility will be
examined by involving the executives of the Venture capital Investor and the
management professional. If required they may even consult the experts In the similar
field to take a decision.
4. Sensitivity Analysis: The Forecasted results of sales and profits are tested and
analysed. The risks and threats will be evaluated by using sensitivity analysis.
Sensitivity analysis helps the evaluators to predict the probable risks and returns
associated with the project. This formally clears the project for investment.

5. Investment in the project: The terms and conditions of venture capital assistance
will be finalised according to the requirement of the project. The amount of funds
required, profile of the business, the life time technology and the possible competition in
the business will be looked into. A formal agreement is entered between the technocrat
and investor stating therein the role of and share of management in the new project.

6. Monitoring the Project and post investment support: The venture capitalist role
begins with financing the project. It is a general practice of the Investor to appoint an
executive director to have closer look in to the project. The executive director assists the
project in developing strategies, decision-making and planning. The process of
interaction with the technocrat increases the healthy environment in carrying the day-to-
day business affairs.

Stages of Venture Capital Financing

The financing of high-tech., project in the form of venture capital financing is done in
several stages.

They may ‘be in the form of:

1. Early-stage financing

2. Later stage financing

(1) Early-stage financing

This stage of financing is done to the new project or to the new technocrat who wishes
to commercialize his research talents. As the technocrat is well versed only with know
how and not with capital, going for debt at this stage increases the risk of entrepreneur
and affect the health of the business unit. In, other means of financing, the obligation to
repay the loans along with interest starts immediately with lending. Hence, it is not
advisable for young entrepreneurs to go in for such loans. They have depend mainly on
equity stoke so that the risk of repayment does not arise equity financing permits the
young entrepreneurs to commercialize and earns profits out of the investment. The
main instruments used for such financial assistance would be in the form of equity
contribution, unsecured loans and optionally convertible securities. Once the financing
is done, venture capitalists assists the firm in general administrative activities and allow
the technocrat to concentrate on production and marketing. This stage of venture capital
financing consists of seed capital, start-ups and second round financing.

(a) Seed capital: Seed capital financing includes the implementation of research
project, starting from all initial conceptual stage. This stage requires more time to
complete the process. Because the entrepreneur made an effort to the maximum to
meet the market potentiality. Therefore external equity in preferred. The key factors that
influence equity financing at this stage are:

The technology used in the project, possible threats of new technology in the
near future.

Different aspects of the product life cycle.

The total investment required commercializing the product and time required
to get suitable returns etc.,

(b) Start-up stage financing: At this stage innovator requires finance to commercialize
the product. This stage is not simple to execute, it requires more time in getting different
elements ie., (patent rights, trade marks, design and copy rights) which are very
essential to bring the product in the market. All these components are very essentially
needed to launch the product effectively. Hence, time and finance is needed. On the
other hand, the research must also be done to evaluate the probable opportunities to
exploit the market. Therefore, venture capital investor evaluates the projects carefully
and negotiate the terms and conditions with the entrepreneur with regard to sharing the
management.

(c) Second round of financing: This type of financing is required when the project
incurs loss or inability to yield sufficient profits. The reasons could be due to internal or
external factors. At this stage, if the venture capitalists is fully aware of the genuine
reasons for the loss, he should decide on second round financing, or he may seek the
support of new investor. This is a complex process as the original investor may express
his inability to further finance the project or entrepreneur must have lost the confidence
with the original investor or he may wishes to broad base the investment pattern. Lot of
bargaining has be done to coordinate the financing with original investor and with the
technocrat or promoter.

(2) Later Stage Financing

Later stage financing is considered to be the easy means of assistance. The reason
being, the product launched has not only reached the boom period but also indicator
further expansion and growth. Hence it is a easy means of financing with low risk
profile. The real problem associated at this stage is entrepreneur not be willing to give
majority of his stake to the venture capitalists but may accept for more number of
executive directors in the board. This means of is also known as expansion finance,
replacement capital, management buy out and turn around capital.

(a) Expansion finance: Later stage financing is executed to expand the market,
production or to establish warehouses etc., Export trade activities may also be
considered for financing the project.

(b) Replacement capital): Under this stage, the promoter may prefer to buy the entire
equity stake of the project by approaching some other financiers. He may also wish to
increase his holding by buying more number of equity shares. Replacement capital) is
normally preferred at the time of public issues. If the company is unlisted, getting capital
gains on the fresh issues needs more time, tilt then replacement capital can be obtained
in the form of convertible preference shares from the second financier.
(c) Management Buy out (MBO): This may be offered in two ways namely.
‘Management buy out’ or ‘Management buy int. In management buy out, venture
capitalist help the management of a company to buy or take over the ownership of the
business. This would help the management to reshuffle or reengineer the entire project.

In management buy in strategies, outsides prefers to buy the existing business. This
means of financing is less risky, it is not considered as venture capital and has wide
criticism.

(d) Rescue Capital: Rescue capital is also known as turnaround capital offered with a
view to help the technocrat or the business unit to come out of difficulties. This means of
financing is risky in nature and the investor may ask for major changes in the
management. In India, venture capital financing for MBO and turnout are rarely seen, as
the majority of the investor prefers to invest only in later stages.

Types of Venture Capital Organizations

On the basis of ownership, management and rising of funds, venture capital

organization are categorised on the following groups:

Captive Venture Capital Funds: These organizations are wholly owned by financial
institutions and are operated as subsidiaries. The parental institutions supply funds for
venture capital assistance e.g.. 1DBI used captive funds to assist venture capital, TDIC
uses the funds for venture capital which is supplied by UTI and ICICI. RCTC used the
funds of UTI and IFCI. All these venture capital investors perform their activities
independently.
Independent Venture Capital Funds: All these funds are raised by group individuals
venture capitalists. These funds are close-ended with minimum capital base and equity
oriented instruments. The investor in such contribution expects huge capital gains,
rather than regular income of dividends. The amount invested in the project will be
realised through the exist route. (Promoter and venture capitalists prefers to go for
primary market to sell the shares and distributes the realised amount as per the terms
and conditions of the agreement.)

Government Funds: These venture capital organizations are wholly owned by the
government. The assistance will be given to promoter at the initial stages to complete
research and developmental activities. To avail such benefits the product innovated
should be of national importance. Government of Karnataka through the Central
Government scheme, provides Rs. 25,000 for the technocrat who commercializes his
know how by obtaining a patent right, the Commissioner of industrial development is
authorised to release this fund through Karnataka Council of Technological upgradation
scheme.

Exit Route of Venture Capital

The main aim of venture capitalist is to realise the investment with huge profit after the
completion of successful efforts with the promoter in launching or commercialising the
product. The exit route will be well thought by the investor at the stage of marking
investments. Exit means realization of investment through the issue of equity shares to
the public. The main motto of venture capitalist is find exit at ‘maximum profit or if it is
unavoidable with ‘minimum loss’. There are alternative routes of disinvestment practiced
in a real life situation. They are:

Going public

Sale of shares to entrepreneurs

Sale of the company to another company

Finding a new investor

Liquidation
(a) Going Public: Most of the venture capital assisted firms prefers to go in for public
issue to recover their investments with profits. This process not only help the
entrepreneur but also the investor in different ways. The main benefit of going public
increases the liquidity of the business firm. This liquidity will increase the percentage
returns over the private placements. (If it were sold through private placements). The
public issues provides another opportunity for the business firm to list its shares in the
stock market. Once the shares are listed, it increases the image of the organization. In
addition to this, it increases and attracts efficient persons to work in the organization. In
addition to this, the commercial banks and financial institutors will forward to offer
different types of loans. If the firm wishes to raise additional capital for expansion and
growth, it could be done easily through the public issue.

However, going public is not an easy route to exit or venture capital assisted units
because, it has to observes several legal for’ of stock exchange. The company must
also disclose part a considerable ar1t of information at the time of issuing the shares;
this could be a sales threat with the global competition. Employees may ask for better
comfort with huge hike in the salaries and perks. The expenditure incurred during the
course of the issue in also substantially high, which may affect the profitability. As the
company is going for public issue, its social responsibility increases and they have to be
accountable to all the organs of the society, which burdens the financial affairs of the
company. With all these demerits or bottlenecks going public for exit route is widely
used in seal life situations.

(b) Sale of shares to entrepreneur: Some times, promoter may prefers to have exit
route through, Over The Counter Exchange by entering into bought out deals with the
member of O.T.C. He may purchase the shares with a view of entering in to the primary
market at the later stage.

In certain circumstances, an entrepreneur himself prefers to buy the entire shares. He

may even buy the shares with the help of his own group-even the employees are
allowed to do so at an agreed price for buying such shares. If necessary, the
entrepreneur may approach financial institutions for loans. The price at which the stake
of the V. C. assisted may be done as several methods. Viz.,

(i) Book value method: According to this method, the price is fixed on the basis of
book value method or a predetermined multiple applied to determine the book value

(ii) Price-earning ratio: This method is widely in practice. The price of the share is
determined as the basis of multiplying the price earning ratio to earning per share.

(iii) Percentage of sales method: Pricing under P/E ratio is popular only when the
earnings are low or the company anticipated losses in the coming years PIE ratio is not
suitable. On such circumstance, percentage of sale method is used. If the sales figures
are highly volatile, the total average sale of the industry is taken into consideration.

(iv) Multiple of cash flow method: According to this method, the value of the business
is determined by multiplying the cash flow of the business by a multiplies which is
similar to the industry. Hence it is considered to be a better method when compared to
PIE ratio and percentage on sales method.

(v) Independent Valuation: Sometimes, the task of determining the value of business
is assigned to professionals like CAs or Merchant Bankers. They may use either
p/eratio method or a traditional method for assessing the value of the assets.
(Realisable value)

(vi) Agreed to this method: Venture capitalist and the entrepreneur follow the price
that was determined mutually at the time of launching business. This is a traditional and
simple method.

(c) Sale of a company to another company: On many occasions, venture capitalist

and the entrepreneur may agree together to sell the business unit to some other
company. The reasons could be many viz., the entrepreneurs may prefer to undertake
some other new company. He may find it difficult to operate the business profitably. At
the time of managerial difficulties he may search for a new company which is having
similar line of business. The modalities of such a sale will be made on the basis of level
of operations and, the nature of venture, which may be acceptable to both the parties.

(d) Finding a new investor: Under this method, the venture capitalists and the investor
may decide to sell the unit to another new investor who may be a venture capitalist or a
corporate who is having similar line of business. But buying venture from others and
buying company may increase their operation and profitability. This provides an
opportunity to exploit and can have economies of large scale operations

(e) Liquidation: This is a lender of last resort, when a firm performs very badly, in other
words if it incurs continuous cash loss over the years, venture capitalist and the
entrepreneur decides to close down the operations. Hence, it takes the firm to
liquidation. The reason for such a exercises would be many viz., stiff competition,
technological failure, poor management by the entrepreneur etc.,