Investment in common stock has been praised as a path to greater returns than other instruments. It has also been blasted as being high risk and potentially reckless. However, firms issuing stock take chances as well. The improper mix of equity and debt financing can cost firms money or even control.
Firms can raise capital by relinquishing part of their equity. Equity is ownership of the firm. One of the greatest disadvantages of equity financing is the fact that any earnings must then be shared with all holders of that equity. For example, if an interest produces a net profit of $100 million in a given year, only $50 million would be retained by the firm if half the equity had been sold. Obviously, the downside to selling equity is increased the more profitable the firm. If a company is struggling or barely breaking even, equity is far more affordable. However, equity is not necessarily an irrevocable loss of ownership. Successful companies can, and do, purchase back their own common stock. This increases their own equity and decreases the proportion of profits that must be paid out to shareholders.
Tax considerations are also a concern for companies issuing stock. Most corporations pay extremely high income tax, sometimes as high as 40 percent in the U.S. However, unlike individuals, who pay taxes on most of their gross income corporations only pay taxes on their profit. A company choosing to finance using debt will have to make payments back to the lender. These payments reduce the net income for the corporation and thus the tax liability for the firm. The end result is this is that in a situation where equity and debt financing would otherwise cost the same, equity financing becomes unattractive because it increases taxes.
Loss of Control
A third disadvantage of selling equity, that is issuing common stock, is that relinquishing ownership not only sacrifices profits but control. Holders of common stock shares get one vote for each share of stock held. While many people do not exercise their right to vote, or allow their votes to be decided by a designated proxy, shareholders who control large portions of stock can exert considerable control over the direction of the company. While individual investors seldom control enough capital to acquire a controlling share of the firm's outstanding stock, institutional investors frequently purchase controlling shares with the intent to acquire other companies as their own. Any entity, individual or corporate, that controls over 50 percent of a publicly traded firm’s stock, can essentially control that firm. The board of directors, the highest echelon of authority in the firm, may be reorganized or even replaced. The decision to buy back or issue more stock can be forced by shareholder vote. The decision to merge with another company can also be made, regardless of the wishes of the board of directors, chairman of the board, president or CEO of the company. This is referred to as a hostile takeover, and decision-makers should consider its risks when deciding whether to issue stock or not.
Jake LeBrun began writing professionally in 2010, with his work appearing on various websites and in his college newspaper. He holds licenses in Louisiana in life and health insurance and specializes in writing about financial topics. LeBrun holds a Bachelor of Science in finance from McNeese State University.