Primary market
The primary market is the creation and sale of new shares. Most of the time you will be buying second-hand shares but we will look first at the different ways in which new shares may be issued to the public.
By the ‘public’ we do not just mean small investors like yourself or wealthy individuals. Shares are also held by large institutions such as pension funds. These are referred to as institutional investors.
Initial public offerings
When a company decides that it wants to raise money by issuing shares to the public for the first time it will make what is called an initial public offering (more usually referred to by the initials IPO).
This is also dubbed as coming to market or a flotation.
The shares issued to the public may be:
· New ones created by the company, in which case any money you spend in buying them will go to the company to be used in expanding the business.
· Existing shares held by the owners of the company who are looking to cash in on their success and are offering some of their shares for sale. In that case, the cash goes to them. The owners may be the people who set up and built the company from scratch and they now want to enjoy the fruits of their labour. It could be a family firm with no one in the next generation wanting to inherit the business.
· A mixture of new shares sold on behalf of the company and a batch of shares from the existing owners.
A prospectus giving all relevant details is issued before an IPO takes place. It will state how many shares are being issued, who the directors are and their history, and whether there are any skeletons in the cupboard such as outstanding lawsuits.
Any investor seeking to buy shares in an IPO can contact the company and request a prospectus, although IPO shares are often issued only to institutional and large investors because it is cheaper and simpler than seeking out a large number of small investors.
It is possible in an IPO that the existing owners intend to retain a certain number of shares. The prospectus will spell this out. It will also indicate if the owners have given an undertaking not to sell any or all of their remaining stakes for a specific period of time. This will alert you to the possible danger that a large slab of shares could be dumped onto the market at some future date, depressing the share price at that time.
Companies that have come to market in the past may create new shares in addition to those issued in the IPO. Sometimes, as in the issue of vendor shares or share options, existing shareholders are not directly affected and no action is required.
Vendor shares
When a company makes an acquisition – in other words, buys another company – it may pay cash, but alternatively it may pay partly or entirely in its own shares. These are new shares issued to the owners of the company that is being bought, the vendors. You will have come across the term vendor, the Latin word for seller, if you have ever bought a house.
Often the vendor will give an undertaking not to sell any of the shares for a set period of time. Alternatively, the vendor may place the shares immediately with institutional investors or keep them as a long-term investment.
Share options
Directors and other key executives at a company may be awarded share options, which means they have the right to buy a set number of shares at a set price. Share option schemes are designed to provide an incentive to management.
The price the managers have to pay to buy the shares is fixed, often at quite a cheap price, so they can pocket a profit by buying the shares cheaply and selling them at a higher price. The better the company is doing, the more the shares will be worth and the bigger the profit the managers can make on their options.
Buying shares in this way is called exercising the options.
Other ways of creating new shares
There are other occasions when companies already listed on the stock market may create more shares:
· Rights issues. Existing shareholders are given the right to buy more shares at a set price.
· Placings. New shareholders are given the opportunity to buy shares at a set price. Placings may also include the right for existing shareholders to participate.
· Bonus issues. Existing shareholders are given extra shares for free, in proportion to their holdings.
· Share splits. Each existing share is divided into two or more shares.
I will deal in greater detail with these share issues, explaining the implications for shareholders and what action if any needs to be taken, in chapter 20.
Secondary market
We have seen that there are various ways in which new shares are created but for the most part you will be buying shares on the secondary market – that is, buying existing shares second-hand. You will do this through the stock market, which we will be looking at in Part Two of the book.
It is quite likely that all the shares you ever buy will be bought on the secondary market. Certainly all the shares you ever sell will be sold on the secondary market.
The cash you pay for these shares does not go to the company. It goes to the person who already owns the shares. When you sell any shares you own, the proceeds of the sale come to you, not to the company.
Share cancellations
Shares can be cancelled as well as created. When a company is taken over, the new owners often buy all the shares from the existing shareholders and scrap the lot.
Less dramatic is the growing trend for companies to buy back some of their shares. This happens when a company has spare cash that is not needed for investment in the business. This process is often referred to as returning cash to shareholders, as it is the reverse of the process we have discussed in the primary market where the company issues shares to investors to raise cash.
Shares are also cancelled in a share consolidation, a process that almost invariably means that the shares have sunk so low in value that they are hardly worth buying. For example, when a share price falls below the level of 1p, the mechanisms for trading shares can become quite impracticable.
Say the consolidation is one share to replace every ten you already own. So if you held 1,000 old shares you now own only 100 new ones. In theory, each new share should be priced on the stock market at ten times as much as the old shares. Unfortunately shareholders often take the opportunity of a share consolidation to sell out, so the price tends to settle below the theoretical price. Hopefully, after reading this book, you will be sufficiently competent at investing to be able to avoid such companies.
Treasury shares
Occasionally a company may buy its own shares cheaply in the hope of reissuing them later through the stock market at a higher price rather than cancelling them. While these shares are held in abeyance they are known as treasury shares.
Incentive schemes for company executives often include the award of shares free or at a favourable price. Treasury shares can be used to meet these awards as they arise.