Time and again corporates have raised funds, and one such route of raising money is pledging shares.
In the past, several corporates, including Vedanta and United Breweries, have raised capital by pledging their shares.
So, what is share pledging and how does it work?
Here, share pledging refers to promoters pledging their shares. In essence, it means promoters take a bank loan, offering shares in a company as collateral.
“The terminology is typically used in fundraising parlance, when promoters of a corporate entity pledge their shares to raise funds as debt for the organisation, or for any other funding needs, be it personal or for investing in any other businesses,” Nirav Karkera, Head of Research, Fisdom, told Moneycontrol.
“Pledging shares is often viewed by promoters as an effective way to monetise the value of their shareholding without ceding associated control,” he added.
In other words, pledging is another fund-raising mechanism.
Do promoters continue to earn dividends on the pledged shares?
Despite the shares being pledged, they will continue to be held in the name of the promoter, which means he/she will maintain ownership and continue to receive dividend payments while they are pledged.
How is the value of the pledged shares determined? Do the parties have an agreement about the value of pledged shares?
The value of the pledged shares changes with the value of the shares as a result of market fluctuations.
Meanwhile, the lender and borrower enter into a contract, which pens the value of the collateral, based on the market price of the securities. This value, mutually agreed between both parties, must be maintained by the promoters.
“The central bank has issued guidelines on the same, with the directive typically allowing for a 50 percent loan-to-value. Such an exercise of lending against securities is done basis a contract entered by the shareholder and lender,” said Karkera.
If the value of the pledged shares (collateral) declines and falls below the amount stipulated, the borrower will need to increase his/her collateral either by bringing in more cash or by adding more shares to the already pledged ones, explained Punit Patni, Equity Research Analyst, Swastika Investmart.
In the event the borrower fails to pay the collateral value, the lender has the option of selling the pledged shares or making up the difference in value.
What happens if the lender is unable to repay?
In case of a default, there will be a loss of control or ownership because the lender can sell the pledged shares to recover its loan.
What are the advantages and disadvantages of pledging shares?
A key positive of share pledging is that it offers the borrower quicker access to funds at relatively lower rates of interest, as compared to an unsecured loan.
“Such a transaction is especially beneficial to a promoter seeking to translate shareholdings into liquid cash without ceding ownership and associated rights,” Karkera said.
The main disadvantage of share pledging lies in the risk to shareholders.
If the borrower fails to repay the loan then the lender has the option of selling the pledged shares in the open market. In case the quantity of pledged shares being sold is significant, the share price of the company is likely to be affected, which, in turn, could trigger a selling spree by other investors as well.
Is share pledging for fundraising good or bad and what does it signify?
Share pledging can be good or bad depending on the situation and the context of the loan.
“Pledging of shares merely signifies that the promoter is seeking to raise funds for a purpose and is unable to or unwilling to fund the same through cash up front or any other form of loans. In such a case, inability warrants caution while unwillingness warrants investigation,” Karkera said.
The main source of wealth for promoters is usually the value embedded in their shares and the dividends they earn every year from the company. So, ambitious promoters usually try and monetise their shares in key companies to fund new ventures.
However, according to Patni, “In case the company in question is financially strained, and its shares are pledged for personal use or investment in any other promoter ventures, it is considered a red signal for the stock.” In the past, some promoters have pledged the shares of poorly performing companies and used the share pledge route as a back-door exit from the stock.Similarly, some promoters pledge their shares to raise funds to buy back shares and increase their shareholding in the pledged company, which is seen as a positive and could prompt investors to buy the stock.