Complete Guide To Corporate Finance

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Raising Capital - New Equity Sales

A company that has already held an IPO can sell new equity in what is known as a secondary offering, a follow-on offering or add-on offering. Usually, these kinds of public offerings are made by companies wishing to refinance or raise capital for growth. The money raised goes to the company through the investment bank that underwrites the offering. A secondary public offering is a way for a company to increase outstanding stock and spread market capitalization (the company's value) over a greater number of shares. However, secondary offerings dilute the ownership position of stockholders who own shares that were issued in the IPO.

Unlike an IPO, which includes a price range at which the company is looking to sell shares, the price of a follow-on offering is market-driven. Because the company is already publicly traded, it has been consistently valued by investors for at least a year before the follow-on offering is floated. Thus, any investment bank working on the offering will often focus on marketing efforts, rather than valuation.

From the existing shareholders' perspective, the issuance of add-on stock is a bad thing because it usually reduces the value of the stock they own. More shares mean that existing shareholders will see their percentage of ownership in the company decrease. They may also see the stock's earnings per share decline. However, if the add-on is able to increase earnings and shareholder value in the long term, it will generally be viewed as a positive decision.


Share Price and Secondary Offerings
Why do share prices fall after a company has a secondary offering? The best way to answer this question is to provide a simple illustration of what happens when a company increases the number of shares issued, or shares outstanding, through a secondary offering.

Suppose XYZ Inc. has a successful IPO and raises $1 million by issuing 100,000 shares. These shares are purchased by a few dozen investors who are now the owners (shareholders) of the company. In the first full year of operations, XYZ produces a net income of $100,000.

One of the ways the investment community measures a company's profitability is based on earnings per share (EPS), which allows for a more meaningful comparison of corporate figures. In its first year of public ownership, XYZ had an EPS of $1 ($100,000 of net income / 100,000 shares outstanding). In other words, each share of XYZ stock held by a shareholder was worth $1 of earnings.

Subsequently, things are looking up for XYZ, which prompts management to raise more equity capital through a secondary offering, which is successful. In this instance, the company only issues 50,000 shares, which produces $50,000 of additional equity. The company then goes on to have another good year with a net income of $125,000.

That's the good news, at least for the company. However, the point of view of the original investors - those who became shareholders through the IPO - their level of ownership has been decreased with the increase in the shareholder base. This consequence is referred to as the dilution of their ownership percentage.

Some simple math will illustrate this event. In the second year, XYZ had 150,000 shares outstanding: 100,000 from the IPO and 50,000 from the secondary offering. These shares have a claim on $125,000 of earnings (net income), or earnings per share of $0.83 ($125,000 of net income / 150,000 shares outstanding), which compares unfavorably to the $1 EPS from the previous year. In other words, the EPS value of the initial shareholders' ownership decreases by 17%!

While an absolute increase in a company's net income is a welcome sight, investors focus on what each share of their investment is producing. An increase in a company's capital base dilutes the company's earnings because they are spread among a greater number of shareholders.

Without a strong case for maintaining and/or boosting EPS, investor sentiment for a stock that is subject to a potential dilutive effect will be negative. Although it is not automatic, the prospect of share dilution will generally hurt a company's stock price. We'll discuss share dilution in greater depth later in this section.

Cost Of Issuing Securities


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RELATED TERMS
  1. Secondary Offering

    1. The issuance of new stock for public sale from a company that ...
  2. Dilution

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  3. Subsequent Offering

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  4. Fully Paid Shares

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  5. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  6. Diluted Earnings Per Share - Diluted ...

    Diluted Earnings Per Share (or Diluted EPS) is a performance ...
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