When we need extra money for our special needs, we take money by mortgaging one of our precious things. Similarly, in the stock market when the company needs extra funds their promoters pledged their shares to fulfil business operation.
Before investing in a company, checking the number of shares pledged by the promoters is very important factor ,which most investors ignored. In a company high pledged of shares may be a cause of concern for investors.
We will discuss here that what is pledging of shares and what are its disadvantage to the shareholders?
1. What is pledging of shares ?
In simple words, the pledging of shares means that borrowing money against the shares available that one holds. This is a way in which the promoters are able to obtain loans by pledging their shares for their personal or business operation. Pledging of shares can be used for various needs, such as to meet the requirements of money, for new acquisitions, etc.
2. Why promoters pledged their shares?
Generally speaking, pledging shares is the last option for the promoter to raise money, which is more secure than the equity or debt. However, if the promoter is thinking of pledging shares, it means that all the fund raising options have been closed.
This type of situation arises occurs slowdown in economy, hence the stock is considered as a assets, hence it is given as a safeguard to borrow from the bank.
3. Why it is risky ?
While pledging shares, promoters use their share as a collateral to secured loans. When the market is in bull faze, the pledging of shares by the promoter does not cause concern for investors as the market remains in bull faze. However problem creates when there is a recession in the market.
Since stock price fluctuates, therefore the value of collateral (against secured loans) changes with the change in stock price. However, promoters need to maintain the value of that collateral.
If the price of shares falls, then the value of collateral will also worsen. To meet the difference in the collateral value, promoters will have to cover the deficit by pledging more shares to the lender. In the worst case, if the promoters fail to reduce the gaps, then the lender can sell pledged shares in the open market to cover their money. It is agreeable to the minimum collateral value in the contract between lenders and promoters. Therefore, it gives the lender the right to sell the pledged shares upon falling below the minimum price.
4. What is the risk for retail investors ?
Generally, the price of the stock falls sharply on the news that the lenders are selling the promoter's pledged shares to the open market. This can lead to further collapse in collateral value due to public panic selling. In addition, the shareholding pattern of the company could also result in the sell of shares pledged by the lenders. This may affect the voting power of promoters, because now they are holding less shares and their ability to make important decisions is low.
Apart from this, the pledge of shares can cause a disaster if the share price falls. This is because promoters have to pledge more shares in order to cover the difference in collateral value.
Conclusion - The pledged shares is usually seen in companies where promoters shareholding is high. As a rule of thumb, the pledge of shares above 50% may be risky for promoters. In short, to avoid unnecessary hassles, ignore companies with high pledging shares.
This is because the pledge of shares is a sign of bad cash flow, low credit eligibility high debt company and inability to meet short-term needs. (If promoters have pledged a high percentage of shares, then it is always useful to know the reasons.) The weak vow of shares over time is a good sign for investors. On the other hand, the growing pledge of shares for both promoters and shareholders can be dangerous. Even if pledge of shares does not decrease over time, quality companies may suffer.
Similarly, if the company has increasing operational cash flows and good prospects, then pledge of shares is not a big concern for them. Many times, the pledged shares helps in the expansion of the company or in making new projects, resulting in increase in revenue in the future. Apart from this, pledging of 5-10% shares in the basically healthy companies should not be considered as a problem.
This is all for this post. I hope this will be helpful for you. Happy Investing!
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