Pledging of shares is one of the options promoters consider to meet various financial needs like working capital requirements, to fund other ventures or acquisitions or even for personal needs. Pledging of shares is similar to pledging any valuable asset you own. In this article, learn about pledging shares, its working, impact on the stock valuation and more.
What Is Pledging of Shares?
Pledging of shares is an arrangement in which the promoters of a company use their shares as collateral to fulfil their financial requirements. While pledging shares, promoters still hold ownership in the company. However, the value of the collateral changes with fluctuations in the market value of the pledged shares.
The promoters must maintain the value of the collateral. The minimum collateral value is agreed upon in the contract. If the value of the pledged shares falls below the amount fixed in the agreement, it triggers a ‘margin call’. In such cases, the promoters must provide additional shares to the lender or pay cash to make up for the shortfall of the collateral.
Banks or lenders can also choose to sell the pledged shares in the open market if the borrower is unable to repay the collateral value or make up for the difference in the values. The pledged shares are lost if sold in the open market; this reduces the promoters’ shareholding and can also impact the stock value negatively.
How Does the Pledging of Shares Work?
The pledging of shares is similar to a loan. Banks or financial institutions offer loans on taking the promoter’s shares as collateral. The value of the pledged shares is decided by the lender and promoter as per the market value of the shares. According to that, they pen down an agreement. They can get a loan after a haircut deduction. According to the RBI, the loan-to-value ratio of 50% should be maintained.
What is a Haircut?
A haircut refers to a percent difference between an asset’s market value and the value that can be used as collateral.
For instance, if the market value of the asset is ₹1,000 and the collateral value is ₹500, the haircut deduction is 50%.
Pledging of shares is favourable in bull markets when the market is moving upwards. In the bear market, if the value of the shares drops, it can be a loss for the promoters.
Impact of Pledging Shares on Stock Valuation
While a small percentage of promoter pledged shares may not cause concern, a high proportion of pledged shares can introduce significant risks that affect a company’s stock valuation. It can result in:
- Highly volatile stock price
For example, consider Company A, which pledged a substantial portion of its promoter’s shares as collateral for a loan when the stock price was ₹100 per share. If an external event triggers a market crash, causing the stock price to plummet to ₹70 per share, the company might face margin calls from the lender.
The company may need to offer additional shares as collateral to compensate for the lower share value. Failure to do so can result in the lender taking ownership of the pledged shares and selling them to recover their losses. For instance, if the lender sells 50,000 shares at ₹70 each, the company can redeem from its losses but could initiate a selling trend in the market.
Consequently, the stock price becomes highly volatile, making it challenging to assess its true valuation accurately.
- Pressure on earnings
Companies with a large percentage of promoter’s shares pledged may experience financial pressure due to the cost of servicing the loans. High interest costs can affect profitability and potentially depress earnings.
- Loss of management control
Promoters who pledge a substantial portion of their shares risk losing management control if they cannot repay the loans. This scenario occurs when lenders sell the pledged shares, reducing promoter ownership.
- Market perception
Pledging shares can affect market perception and investor confidence. Investors often view high levels of pledged shares as a sign of financial stress or lack of confidence in the company’s prospects.
- Value trap for investors
Stocks with a high percentage of pledged shares may appear undervalued and attractive to value investors. However, the interest costs, combined with slower growth rates, may limit the actual value these stocks add to an investment portfolio.
Is Pledging of Shares Good or Bad?
Pledging shares has both advantages and disadvantages. On the positive side, it offers access to capital for various needs, enabling liquidity management without asset sales and facilitating strategic investments. A few promoters use the company’s shares to fund other ventures and simultaneously benefit from the dividends offered by the company.
However, the downside includes increased risk due to potential margin calls, negative market perceptions leading to stock price volatility, and the risk of losing control of the company if repayment is problematic. Therefore, the goodness or badness of share pledging lies in the purpose, management’s ability to handle it, and its alignment with long-term financial goals.
How To Find Out if the Company Has Pledged Shares?
Every promoter who pledges shares of a company reports it in their financial statements. You can find out whether a company has its shares pledged by looking into its quarterly earnings. You will get the percentage of promoter holding and the percentage of the pledged shares.
What Does Pledging of Promoters’ Shares Mean?
Pledging of promoters’ shares is a financial practice where the founders or major shareholders (promoters) of a company use their own shares as collateral to secure loans or credit facilities from financial institutions, banks, or other lenders. This essentially means that these promoters offer their ownership stakes in the company as a guarantee or pledge to the lender in exchange for access to funds.
Is Pledging of Promoter’s Shares Bad?
It may be a good strategy if the cash flow is strong. However, one must weigh both the pros and cons before pledging promoter’s shares.
Pros:
Capital Access: Pledging allows promoters to raise funds for various purposes, including business expansion, acquisitions, or personal financial needs, without selling their shares, which could result in a loss of control.
Ownership Retention: Promoters maintain ownership and control of the company while using their shares as collateral, allowing them to participate in future profits and decision-making.
Liquidity: Pledging offers a source of liquidity without diluting ownership or ceding control. This can be particularly useful when other financing options are limited.
Cons:
Market Risk: If the stock price of the pledged shares falls significantly, it can trigger margin calls or forced selling, potentially leading to a loss of ownership or control and financial distress for promoters.
Reduced Market Confidence: Investors and stakeholders may perceive high levels of pledging as a sign of financial stress or a lack of confidence in the company’s prospects, which can impact the company’s stock price and reputation.
Interest Costs: Borrowing against pledged shares often involves interest payments, which can erode profits and increase financial burdens, especially if the borrowed funds are not used wisely.
Lack of Diversification: Pledging a significant portion of one’s shares limits diversification, leaving the promoter’s wealth tied to the performance of a single company’s stock, and increasing overall risk.
How Does It Work?
Pledging shares provides a means for promoters to access capital without selling their ownership stake. Here’s how it typically works:
Promoter Ownership: Promoters often hold a significant portion of a company’s shares, demonstrating their commitment and belief in the business.
Collateralisation: To raise capital for various purposes such as business expansion, personal needs, or acquisitions, promoters pledge a portion of their shareholding as collateral to a financial institution or lender.
Loan Approval: After pledging the shares, the lender evaluates the creditworthiness of the promoter and the value of the collateral. If approved, the lender disburses the loan or credit facility to the promoter.
Interest and Terms: The loan typically comes with an interest rate and specific terms, including a repayment schedule. Promoters are responsible for servicing the loan, including paying interest.
Risk Management: Promoters must closely monitor their pledged shares’ value. If the share price falls significantly, it can result in the collateral’s value dropping below the loan amount, potentially leading to margin calls or forced selling.
Recovery or Consequences: Once the loan is repaid, the pledged shares are returned to the promoter. However, if the promoter defaults on the loan, the lender may sell the pledged shares to recover the outstanding debt.
How Does It Affect Stock Valuation?
Pledging shares is a common practice for companies to raise capital from lenders. Usually, the lender and promoters agree to a certain contract value to create a margin of safety against the loan. If there is a sudden fall in the stock price, it can reduce the value of the collateral. To avoid a decline in collateral value, the lender may ask promoters to cover the cost of the difference. Promoters can cover the difference by pledging more shares. If promoters are unable to meet a margin call, the lender may sell the shares to recover losses. When multiple promoters invoke their pledge, the share price may experience a sharp fall.
Conclusion
Pledging of shares can be a common practice in the share market for promoters. However, as an investor, you need to be aware of the pros and cons of investing in such companies. Ensure to talk to your financial advisor before investing. To invest in the stock market, you must have a Demat account. Open a Demat Account now on Angel One for free. Happy Investing!
FAQs
What are pledged shares?
Pledged shares means the shares that have been used as collateral for a loan. The promoter (borrower) holds ownership of the shares, but the lender has the right to sell the shares if the borrower defaults on the loan.
Why do promoters pledge shares?
Promoters pledge their shares to raise capital for personal or business needs, including funding new projects, acquisitions, or meeting financial obligations without selling their ownership stakes.
Is Pledging a Risky Practice?
Pledging shares carries risks, particularly when the level of pledging is high or in volatile market conditions. It can result in loss of control, negative investor sentiment, and financial repercussions if not managed carefully.
What is unpledging of shares?
Unpledging of shares is the process of releasing pledged shares from the lender. Once the loan is repaid, the lender will release the pledged shares, which are added back to the shareholder’s Demat account.
How many shares can promoters pledge?
Promoters can pledge any percentage of their holdings to banks. However, pledging more than 50% will increase the risk for the company. Hence, you may avoid investing in a company with high promoter pledges to avoid any risk.
What happens if the value of pledged shares falls below the loan amount?
If the value of pledged shares drops significantly, it can trigger margin calls. To meet these calls, promoters must either deposit additional collateral or repay the loan, potentially leading to financial strain.
What is a zero promoter pledge?
A zero promoter pledge means that promoters didn’t lend any shares to the banks for cash. It is always wise to consider the status of the promoter’s pledge before investing in a company.
