It’s another question, which I have received in real life. As it happens, when I first started in accounting, it was somewhat a mystery to me as well. As the name suggests, it’s related to ‘share capital’ and any change within is related to any transaction with shares. But the question, why would someone create this premium, still remains.

In short the theory behind the ‘share premium’ is as follows: in case issuing new shares one can determine the face and the nominal value of a new share. The difference between is shown as a ‘share premium’. The reason why those two values differ and are essentially used comes from legal requirements and not in what you may be thinking now. By law no-one can oblige you to pay more than the nominal value stated but in case the face value or the price to be paid is determined by the shareholders to be different from the nominal value, it’s the amount that needs to be paid. Just for clarification, to put things into figures, if a nominal value of a share is 100 and the face value is 150, than the 150 is the amount that needs to be paid.

But why are they different? The legal requirements which I mentioned above may require that your total equity is at a certain level and relates to share capital somehow. There may be requirements where the total equity may not fall lower than let’s say half of the current registered share capital for an example. In this case, when the shareholders wish or need to invest more money into the company, should not carelessly increase the share capital with every issuance. They’d rather keep the investment into the share capital as low as possible and generate share premium instead. When it matters, is in case of huge losses earned, since they tend to decrease the equity. In case the equity decreases, it may reach the lowest level of share capital allowed by statute. And with this another insertion of resources is necessary.

So think before issuing new shares. When the nominal value is usually pre-determined either by law or some other form of document in the company, the face value is something that can be whatever needed or decided. You can basically have the nominal value as a 100 and the face value as a 10,000. Note here that your local legislation may have some restrictions here, so do consult, but in a nutshell this is how the share premium works.