Established companies that need to raise more capital have three choices: They can sell off assets to raise cash, they can issue a bond or secure a line of credit or they can recruit capital from investors in exchange for a share of ownership. When companies that have already raised a round of equity capital choose the last option, it is called a "seasoned equity offering," or "secondary offering."
Advantages and Disadvantages
The advantage of choosing a seasoned equity offering over borrowing money is that the company will take on no additional debt. The net assets of the company will increase, and will not be offset by debt on the balance sheet. The disadvantage, however, is that existing stockholders will have a proportionately smaller ownership interest in the company, to make room for the new shareholders. Every dollar the company makes in earnings in the future must be split more ways -- a phenomenon called "dilution," or "dilutive effect."
Calculating Value Dilution
To calculate the effect of issuing additional shares in a company on the value of the existing shares of the company, determine how much of a stake in the company is being sold, and for how much. If the company valued at $40 million is selling 25 percent of its equity for $10 million, then the total value of the remaining 75 percent is $30 million. This means that existing shareholders are giving up $10 million of equity in return for the cash.
Calculating Earnings Dilution
Just as the current market value of the pre-existing shares is diluted by a seasoned equity offering, so are future earnings of the company. For example, prior to a seasoned equity offering, a company with 1 million shares outstanding and $1 million in earnings may be allocated a dollar per share in earnings. However, if the company issues another 500,000 shares, that same dollar in earnings must be allocated across 50 percent more shares. The new earnings per share is $1 million divided by 1.5 million shares, or just under 67 cents per share. Existing shareholders, then, pay a price for the additional capital they can raise in a secondary offering.
To protect existing shareholders, many companies will issue warrants, or the right to purchase additional shares, along with the shares of the original stock. This gives the original shareholders the opportunity to contribute to the capital needs of the company themselves, in exchange for more shares, and protect themselves from the effects of dilution. However, if a company has a significant number of options or warrants outstanding, and these option holders exercise their options "in the money," some of the profits that would normally accrue to the long-term shareholders go to the option holders instead.
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