Those who invest regularly sometimes do not have access to liquid cash. Exchanges know that. Using this knowledge to advantage, some of them allow the pledging of shares. This will enable them to keep the wheels of their business turning while allowing investors to keep holding.
What is pledging of shares?
Pledging of shares is a common practice on exchange platforms. It allows shareholders to use their shares as collateral to obtain loans. By selling shares, investors raise funds for various purposes, such as business expansion, debt consolidation, or personal needs. High-net-worth individuals and institutional investors also use the practice.
The shareholder who pledges the shares retains ownership of the shares. They can continue to receive dividends and enjoy related benefits, such as voting rights. The lender can sell the pledged shares if the borrower defaults.
However, pledging shares involves risks that investors should be aware of. In this article, we will discuss the concept of pledging shares, how it works, its benefits and risks, and when and how to pledge shares.
How does the pledging of shares work?
The process of pledging shares usually involves several steps. First, the shareholder contacts a lender and proposes to pledge their shares as collateral for a loan. The lender then conducts due diligence on the borrower and the shares. The point is to determine the value of the collateral and the loan amount.
Once the loan is approved, the borrower signs a pledge agreement with the lender. The agreement outlines the terms and conditions of the loan, specifying the number of shares being pledged, the loan amount, the interest rate, and the repayment schedule. The borrower transfers the pledged shares to the lender, who holds them until repayment.
During the loan term, the borrower continues to enjoy benefits associated with the shares. However, they cannot sell the shares without the lender’s permission. Only if the borrower defaults on the loan the lender gets the right to sell the shares and recover the loan amount.
What are the benefits of pledging shares?
Pledging shares offers several benefits to shareholders. First, it allows them to raise funds without selling off. Unlike selling shares, pledging preservers holders’ ownership rights and control. Second, pledging offers a lower cost of financing than other borrowing forms. Third, it allows shareholders to obtain financing quickly, eliminating the need for extensive documentation or credit checks.
The practice is also beneficial for lenders. It gives them secure collateral for the loan. The shares can be sold in the market to recover the loan amount in case of default. Lenders also earn interest on the loan. This provides them with a source of income.
What are the risks of pledging shares?
Pledging shares is not without risks. The biggest one is that if the borrower fails to repay the loan, the lender may sell off the shares to recover their dues. Should this happen, the pledger loses their ownership rights, and the value of shares may depreciate due to the forced sale.
Another risk is that the lender may impose a margin call if the value of the shares falls below a certain level. In such a case, the borrower has to either provide additional collateral or repay the loan. If the borrower can’t do either, the lender may sell the shares.
Furthermore, pledging shares may also lead to losing control over the company. If a promoter pledges a significant portion of their shares, they may lose control over the company if the lender sells them.
When should you pledge shares?
Pledging of shares should be done only when necessary and after considering all the risks. Investors should pledge their shares only when they need funds for a short period and have a clear plan for repayment. Pledging shares for long-term investments is not advisable.
Promoters of companies should also be cautious while pledging shares. They should do it only if it’s necessary and after considering the impact on the company’s financial health. Pledging may also lead to a loss of investor confidence, thus affecting the company’s credit rating.
How to pledge shares
One must approach a lender who offers loans against shares to pledge shares. The lender may be a bank, financial institution, or Non-Banking Financial Company (NBFC). The borrower must furnish all details of the shares they wish to pledge.
Once the lender approves the application, the borrower must sign an agreement. This agreement contains the terms and conditions of the loan, including the interest rate, repayment period, and consequences of default. It also includes the details of the shares pledged.
After signing the pledge agreement, the shares move from the lender’s account to the borrower’s. The lender holds the shares as collateral until the borrower repays the loan in full. In default cases, the lender can sell the shares and recover their dues.
In conclusion, pledging shares is a useful way for companies and individuals to raise funds. However, it is important to understand the risks involved in pledging shares, as defaulting on payments can result in a loss of ownership.