What is capital?
The general term ‘capital’ is used to refer to the funds available to run the business of a company. For example, you may hear in the media, professionals advising that a business needs an ‘injection of capital’. All it means is that the company requires more finance or funding to run its business.
In company law, the term ‘share capital’ relates to the money raised by the issue of shares. The share capital is contributed by investors in the company and is represented by shares that are issued to such investors.
Why does a company need funds?
When a company is set up, funds are needed to get the business started, e.g. to pay rent, buy stock and machinery, etc.
Funds are also needed to keep the business going – this is commonly known as ‘working capital’.
Funds are also needed for expansion and growth, e.g. by taking on new premises or buying other businesses.
How does a company fund its business?
There are various ways in which a company can raise funds, including by:
- issuing shares, i.e. ‘equity finance’;
- borrowing, i.e. ‘debt finance’;
- issuing a ‘hybrid’ investment which has the characteristics of both debt and equity (for example a convertible bond or a preference share); and/or
- retaining its profits for use in the business (rather than paying the profits to the shareholders).
Equity finance: what are shares?
A share is often described as a ‘bundle of rights’. By investing in the share capital of any company, the investor becomes a part owner of the company and will often have voting rights in shareholder meetings. In the case of a private company, most investors make a long-term investment and will only usually get their investment back on a sale of their stake, a sale of the company itself, on a flotation, or when the company is wound up (provided sufficient funds are available). The incentives for investing would be the receipt of income (by way of dividend) and a capital gain (by way of the growth in the value of the company, and therefore the individual shares), although neither are guaranteed.
Different classes of shares may carry different rights and entitlements. All rights and entitlements in relation to shares of all classes are set out in the articles of association. It is imperative to check these.
Equity finance: effect on the Balance Sheet
Blue Moon Limited, a new company, issues 100 ordinary shares of £1 each for cash on incorporation. The effect on the Balance Sheet of the company is set out below.
| Blue Moon Limited Balance Sheet as at [date] |
||||
| Before issue | After issue | |||
| ASSETS (cash) | 0 | 100 | ||
| Less LIABILITIES | (0) | (0) | ||
| NET ASSETS | 0 | 100 | ||
| SHARE CAPITAL | 0 | 100 | ||
| RETAINED EARNINGS | (0) | (0) | ||
| SHAREHOLDER FUNDS | 0 | 100 | ||
As you can see, the entry for the issue of the shares is as follows:
- increase share capital to show the nominal value of the shares issued; and
- increase the cash (current assets) to show the cash received for the shares.
i.e. the top half of the balance sheet shows you what the company owns and the bottom half shows you where it came from.
Debt finance
Companies will often borrow funds for their business. Money can be borrowed in a variety of different ways, for example by way of overdraft, term loan and bonds.