Rights and position of equity shareholders


Right to income

The equity investors have a residual claim to the income of the firm. The income left after satisfying the claims of all other investors belongs to the equity share holders. This income is simply equal to profit after tax minus preferred dividend.

The income of equity shareholders may be retained by the firm or paid out as dividends. Equity earnings which are ploughed back in the firm tend to increase the market value of equity shares and equity earnings distributed as dividend provide current income to equity shareholders. For example, if a firm earns Rs. 15 million during the year and pays dividend of Rs. 8 million, the value of equity shares may rise by about Rs. 7 million, the amount retained by the firm. The equity shareholders thus receive benefits in two ways: dividend income of Rs. 8 million and capital appreciation of Rs. 7 million.

It may be noted here that equity shareholders are entitled to dividend that is declared by the board of directors. The dividend decision is the prerogative of the board of directors and equity shareholders cannot challenge this decision in a court of law. In this respect the position of equity shareholder differs markedly from that of suppliers of debt capital. Debentures holders, for example, can take legal action against the company for its failure to meet contractual interest payment and principal repayment, irrespective of the financial circumstances of the company. Equity shareholders, on the other hand, cannot challenge the dividend decision of the board of directors in a court of law, however impressive the financial performance of the company may be.

Right to Control

Equity shareholders as owners of the firm elect the board of directors and have the right to vote on every resolution placed before the company. The board of directors, in turn selects the management which control the operations of the firm. Hence, equity shareholders in theory, exercise an indirect control over the operations of the firm.

How effective is such indirect control? Often such indirect control is weak and ineffective because of the apathy and indifferent of most of the shareholders who rarely bother to cast their votes, by post or through a proxy let alone attend the annual general meetings. Scattered and ill-organized, equity shareholders fail to exercise their collective power effectively. Usually, the management of the firm, with the support of a well organized but not a very substantial group of shareholders, is able to hold the reins of control. The proxy system helps the management further. If the shareholders are satisfied, they may sign the proxy in favor of management, authorizing management to vote on their behalf. This system may confer a distinct advantage to the management in the voting process.

Pre-emptive Right

The pre-emptive right enables existing equity shareholders to maintain their proportional ownership by purchasing the additional equity shares issued by the firm. The law requires companies to give existing equity share holders the first opportunity to purchase, on prorata, basis, additional issues of equity capital. For example, if the company has 1,000,000 outstanding shares of equity stock and proposes to issue 200,000 additional equity shares, an equity share holders owning 100 shares has the right to purchase 20 of the 200,000 new shares before those are offered to anyone else. The equity share holders may, however lose this right, partially or totally, as per management’s request if this right creates problems or hindrances in issuing additional shares.

This pre-emptive right ensures that the management cannot issue additional shares to persons or groups who are favorably disposed towards it and there by strengthen its control over the firm. More important, the pre-emptive right protects the existing share holders from the dilution of their financial interest as a result of additional equity issue. This point may be illustrated by a numerical exaple.

PE Ltd. (PEL) has 1,000,000outstanding equity shares with a par value of Rs. 10 and a market value of Rs. 20. The firm plans to issue 500,000 additional equity shares at a price of Rs. 12 per share. The market value per share after this issue is expected to drop to Rs. 17.33. Now, if a shareholder has 100 shares in the outstanding equity capital, his financial situation with respect to PEL’s equity when he enjoys the pre-emptive right and when he does not enjoy the pre-emptive right would be as shown below.

Pre-emptive Right

Value of initial
Holding (Rs. 20 x 100) = Rs. 2,000.

Additional Subscription
(Rs. 12 x 50) = Rs. 600.

Value of equity holding
After the additional issue
(Rs. 17.33 x 150) = Rs. 2,600.

No Pre-emptive Right

Value of initial
Holding (Rs.20 x 100) = Rs. 2000

Additional subscription = 0

Value of equity holdings
After the additional issue
(Rs 17.33 x 100) = Rs. 1,733

The expected price is calculated as follows:

1,000,000xRs.20 + 500,000xRs.12 / 1,500,000

From this example it is clear that the shareholder suffers dilution of financial interest when the pre-emptive right is not enjoyed – the market value of his holding falls from Rs. 2,000 to Rs. 1,733. When the pre-emptive right is exercised, such dilution, however, does not occur and the market value of his shareholding after the pre-emptive issue is equal to the market value of his holding before the pre-emptive issues plus the amount of additional subscription he makes in the exercise of his pre-emptive right.