Shares issued at a premium are a common practice among companies. It is especially true during times of growth or expansion. But what does it mean, and why do companies do it? In the article, we will explore the concept of shares issued at a premium and the reasons behind it. We’ll also see the benefits it can bring to both companies and investors.
The practice of issuing shares at a premium is a significant step for a listed company. Why? Because it provides companies with a way to raise capital. The funds so raised can be used for expansion, modernization, investment, or debt repayment.
It is also an attractive option for investors as issuing shares at a premium provides an opportunity for higher returns on investment (ROI).
However, the decision to issue shares at a premium has legal and accounting implications that need to be carefully considered.
Now, let us get into the details right away.
#1. Meaning of Shares Issued At A Premium
What does it mean by shares issued at a premium?
Shares issued at a premium refer to a situation where a company offers its shares at a price higher than its face value. In India, the par value of a share is typically a positive whole number, such as Rs.1, Rs.2, or Rs.10. However, the par value cannot be in fractions, such as Rs.1.5 or Rs.2.5.
Suppose there is a company named ABC that has shares with a face value of Rs.2 per share. It decides to sell the shares at Rs.52 per share during its IPO. In this case, the share is said to be issued at a premium of Rs.50.
The premium is calculated as the difference between the selling price and the face value, which in this case is Rs.50 (52 – 2).
#2. Authorized Capital Vs Issuing Shares At Premium
What is authorized capital?
It is the maximum amount of shares a company can issue to raise capital through the equity route. Authorized Capital = Total Number of Shares x Face Value.
Authorized capital and its break-up between the number of shares and face value, is mentioned in companies Memorandum of Association (MOA). It is a legal document prepared by the company during its formation and registration.
[Note: It is possible to increase the authorized capital at any time, but after taking the approval of the shareholders of the company. The Registrar of Companies must also be notified and complied with in this regard.]
Example: Authorised Capital for Axis Bank.
- Total Nos of Shares that can be issued by Axis Bank as per MOA (N): 425 Crore numbers.
- Face Value of Each Share (FV): Rs.2
- Authorized Capital = N x FV = Rs.850 Crore (425 x 2).
Authorized Capital & Shares Issued At Premium
It is important to understand the limitation of Authorised Capital clearly. What is its limitation? Let’s take a quiz. Which of the following statement is correct?
- First, Axis Bank (a company) cannot raise funds more than its authorized capital (Rs.850 Crore) indicated in MOA, or
- Second, Axis Bank (a company) cannot sell shares of more than 425 crore numbers as indicated in MOA.
Which of the above statements is true? The second statement is true. Axis Bank cannot issue more shares than 425 crore number.
While a company is allowed to sell its shares at a premium, it cannot issue shares beyond its authorized capital limit without amending its memorandum of association.
The utility of authorized capital is that it provides a framework for the company to plan its future capital requirements. This way the company can issue new shares in the future without having to go through the process of increasing its authorized capital every time it wants to raise additional capital.
Is there any limit to the shares being issued at a premium price (above its face value)?
There is no specific limit on the premium amount that a company can charge for its shares. But the premium must be justified by the company’s financial position and the prevailing market conditions. Read here to know how to justify the premium pricing of the shares.
Additionally, the company must obtain approval from its board of directors and shareholders for the issuance of shares at a premium.
Example of Authorized Capital vs Shares Issued At A Premium
Let’s see hypothetical examples of how much fund Axis Bank can raise by issuing shares at different price levels.
- Option#1: Axis Bank issuing shares at par. It can raise a maximum of Rs.850 crores. Funds raised = N x FV = Rs.850 crores (425 x 2)
- Option#2: Axis Bank issuing shares at a discount of 50%. It can raise a maximum of Rs.425 crores. Funds raised = N x (FV*50%) = Rs.425 crores (425 x 1)
- Option#3: Axis Bank issuing shares at a premium of Rs.50. It can raise a maximum of Rs.22,100 crores. Funds raised = N x (FV+Premium) = Rs.22,100 crores [425 x (2+50)]
It is generally not allowed to issue shares at a discount to the face value in India. As per the Companies Act, 2013, a company can issue shares only at face value or at a premium.
However, there are some exceptions to this rule. A company can issue shares at a discount to the face value in certain cases. When the shares are issued to its employees under an employee stock option scheme or to its creditors under a debt restructuring plan.
In such cases, the discount must be approved by the company’s board of directors and shareholders.
#3. Reasons For Shares Issue At A Premium
A company may decide to issue shares at a premium for various reasons:
- Raising Capital: One of the primary reasons for issuing shares at a premium is to raise capital for the company. By issuing shares at a premium, the company can raise more capital than it would by issuing shares at face value.
- Improving Future Earnings: A company can issue shares at a premium to fund research and development, capital expenditure, acquisitions, etc. This will eventually increase the company’s revenue profits over time.
- Debt Repayment: A company may also use the proceeds from issuing shares at a premium to repay its debts. Reducing its debt burden will improve its creditworthiness.
Overall, issuing shares at a premium provides companies with greater flexibility in raising capital and helps them achieve their financial goals more efficiently.
#4. A Way To Justify The Issuance of Shares At A Premium
Suppose a company ABC wants to issue one crore number shares in its IPO. It wants to issue it at a premium price of Rs.150 per share. The Face Value of these shares is Rs. 2 per share.
In the last 4 quarters, the company has made a profit (PAT) of Rs.10 crores. Also, in the next five years, the company expects a CAGR growth of 18% CAGR.
Let’s use this hypothetical example to justify the IPO price of this share.
- P/E Ratio: The current PAT of the company is Rs.10 crores. The number of shares being issued is one crore numbers. Hence, EPS will be Rs. 10 per share. If the company gets listed at Rs.150 per share, it means its P/E ratio will be 15 (150/10). At a PE multiple of 15, the company can be said to be reasonably priced.
- PEG Ratio: At the current fundamentals, the company is expected to grow its EPS at the rate of 18% per annum. Assuming the PE of 15 as calculated above, the PEG ratio of this company is 0.833 (15/18). As the PEG is less than one (1), Rs.150 per share price level looks undervalued.
Both the metrics, PE and PEG, suggest that even at a premium pricing of Rs.150 per share, the shares look undervalued. One can use this simple method to justify (cross-check) the premium IPO pricing of shares.
#5. Benefits of shares Issue at a premium
There are two distinct benefits of issuing shares at a premium.
- Short-term benefit: The higher the premium, the lesser the number of shares that needs to be issued. This means the promoter’s holdings remain higher.
- Long-term benefit: Lesser number of shares issued means, the dividend per share will be higher. Existing shareholders will get a better dividend yield.
In other words, the lesser the number of shares issued, the better it is for the promoters and the existing shareholders.
Coming back to our example company ABC. Suppose, it needs Rs.100 crore for its future expansion & modernization plans. At a face value of Rs.2 per share, even issuing the full one crore number of shares will guarantee only Rs.2 crores. But if it issues the shares at Rs.150, issuing only 66.66% of the authorized shares will ensure fundraising of at least Rs.100 crores.
What ABC should do? Issue its shares at a premium as shown below:
The highlights of the above example are two:
- First: The company can generate the needed funds.
- Second: Even after the issuance of shares to the public, the promoters still hold about 33.3% shares of the company.
#6. Accounting in Balance Sheet
When a company issues its shares at a premium, the fund thus generated are shown in the company’s balance sheet. Let’s take the example of ABC to get a better understanding.
- Face Value = Rs.2 per share.
- Nos. of shares issued = 67 Lakhs.
- Selling Price = Rs.150 per share.
The premium earned upon the sales of shares cannot be shown as equity share capital. Its accounting is done like this:
- The equity share capital will show the number of shares outstanding times the face value of each share.
- Security premium account will show the number of shares outstanding times the premium earned for each share.
Example of Balance Sheet Entry (Asset & Liability Balance)
A company called EXAMPLE INC. had an authorized capital of Rs.100,00,000. The same has been divided into shares of Rs.2 each (Face Value). The company issued 30,000 shares to its Promoters and 50,00,000 shares to the public at a price of Rs.12 per share (premium of Rs.10 per share).
The balance sheet entry of this transaction will look like this:
- Total nos of shares issued = 80,00,000.
- Total Selling Price = Rs.12 per share.
- Total Fund generated = Rs.9.6 Crore (80,00,000 x 12).
- Face Value = Rs.2/share.
- Premium = Rs.10/share.
[Note: Paid-up capital should always be less than or equal to the Authorised Capital. Read more about paid-up capital, issued capital, authorized capital, etc here].
There are legal implications in India for issuing shares at a premium. According to the Companies Act, 2013, a company can issue shares at a premium only if it satisfies certain conditions.
- Bank Account: As per Section 52 of the Companies Act, 2013, the amount of the premium must be credited to a separate account called the “Securities Premium Account.” The premium must be received in cash only.
- Records: The company must maintain a proper record of the premium received.
- Usage of Funds: As per Section 52(2) of the Companies Act, 2013, the securities premium account can be used for specific purposes as stated here. (a) To write off the expenses of issuing shares or debentures. (b) To fund the premium payable when preference shares or debentures are redeemed. (c) To buy back the company’s shares in accordance with the provisions of the Companies Act, 2013. (d) To provide for the issue of bonus shares to the members of the company.
If a company issues shares at a premium without complying with these conditions, it may be subject to penalties and legal action.
Issuing shares at a premium is a popular practice among companies to raise capital for their expansion, modernization, investment, or debt repayment needs.
For the investors, it is an investment opportunity as the company that is selling at a premium during its IPO might see newer heights.
However, it is also important to note that issuing shares at a premium has legal and accounting implications, for the issuer, that needs to be carefully considered.
Authorized capital is the maximum amount of capital that a company can raise through the equity route. It is a legal limit on the maximum number of shares that a company can issue to its shareholders.
It also provides a framework for the company to plan its future capital requirements. The company can issue new shares in the future without having to go through the process of amending the Memorandum of Association (MOA)
While there is no specific limit on the premium amount that a company can charge for its shares, the premium must be justified by the company’s financial position. An over-expensive stock (IPO) may not find enough investors. So finalizing an optimum IPO is essential.
The company must also obtain approval from its board of directors and shareholders for the issuance of shares at a premium.