A:

Additional equity financing dilutes existing shareholders. There are two types of candidates for equity financing. One is an early-stage growth company looking to take advantage of favorable market conditions to raise money. The other is a struggling company that cannot access credit markets and resorts to equity financing to raise money.

Equity financing is basically the process of issuing and selling shares to raise money. By creating these shares, it lowers the value of existing shares. For example, consider a company that has 1,000 shares in existence, trading at $10 per share. The company needs to raise money, so it decides to issue another 100 shares and sell them into the market.

Of course, the company's value has not changed due to this sale, but there are now 1,100 shares in circulation. In addition to its value not changing, its earnings and revenue remain the same. However, on a per-share basis, these values drop. Basically, the additional funds to the company come at the expense of the shareholders.

In most cases, equity financing leads to drops in the share price, so they are avoided. Desperate companies on the verge of bankruptcy often resort to it as they are shut down from credit markets. This is often the beginning of a downward spiral, as shareholders begin selling in anticipation of such dilution.

Occasionally, early stage growth companies with an optimistic investor base can see increases in the share price on equity financing. A recent example is Tesla Motors in May 2013, when it issued 3 million shares at the market price and said it would use the proceeds to pay off debt. The stock rose nearly 10% the next day. This type of price action reveals strong demand for the stock and investors' faith in management to use the proceeds judiciously.

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