Shares are regarded as assets. The promoters of a firm can get loans to cover their personal or professional needs by pledging their shares as collateral to lenders. Shares can be pledged to cover a variety of expenses, including personal responsibilities, working capital needs, funding for other projects, making new purchases, and more.
Pledging of shares is prevalent in firms that have large levels of investor ownership. Shares that have been pledged as collateral nevertheless belong to the borrower, who also continues to receive interest and capital gains on those shares.
How does pledging of shares work?
The promoters are prohibited from trading their shares after pledging them until the debt has been repaid. Because the market is unpredictable and dynamic, the lender will grant a loan for a sum that is significantly less than the value of the shares as of that date. Varied lenders have different criteria and lending rates depending on the market value of the shares in the case of a bank or financial organization.
The market is volatile and unpredictable, as we all know. Determining whether the value of pledged shares will increase or decrease in the future is therefore impossible. As a result, they include terms & conditions in their agreement with the promoters to guarantee that the lenders have adequate security against the loan.
Promoters may need to provide balance as cash or further pledge their shares in order to cover the difference between the "amount needed for security" and the "market value of the shares" in the event of a decline in the market value of shares.
If the promoters are unable to make up the deficit, lenders may be able to recoup their money by selling the shares on the open market. This may result in the promoters' ownership of the firm decreasing, the stock's value declining further as a result of the influx of new paper into the market, or even a rapid change of leadership owing to the company's shareholding structure.
Share pledging is a common method for businesses to raise capital, but unpleasant experiences in the past have left a bad perception of the instrument since it denotes poor cash flow patterns, a credit crisis inside the business, and promoters' inability to address urgent working capital needs.
The firms view this strategy as a last alternative for obtaining funding from lenders. Due to the potential impact on the firm's reputation, the corporation prefers against providing shares as collateral.