What it means
When a company needs money and chooses to raise it from owners rather than lenders, it can issue new shares in a primary offering. The first time a private company does this publicly is the initial public offering, or IPO.
A company that is already listed can do it again later, in what is often called a follow-on offering. The key feature is that the shares are brand new.
Because the number of shares in issue goes up, each existing share represents a smaller slice of the company, which is called dilution. The trade-off for dilution is that the business receives cash without taking on debt or interest payments.
Companies use the proceeds for many purposes, including building capacity, funding research, paying down borrowings or buying other businesses. The offering document, called the prospectus, must state how the money will be used.
Investors judge the offering on whether the plan is likely to earn a return greater than the dilution costs. The costs are substantial.
Underwriters take a fee, and legal, audit and listing expenses add to it. The share price often falls slightly on announcement of an offering, because investors expect dilution and may read the sale as a sign that management believes the shares are fully valued.
Many offerings combine a primary component with a secondary component where existing holders sell some shares. It is worth reading the details to see how much of the money reaches the company and how much goes to selling shareholders.
Companies sometimes offer existing shareholders the first chance to buy the new shares in proportion to their holdings, which is called a rights issue. This lets owners avoid dilution if they take up the offer.
Other offerings go straight to new investors, who may be offered a small discount to attract demand.
In practice
Real-world examples.
Example
A software company floats on a stock exchange and sells new shares to fund product development. The cash goes onto the company's balance sheet and the founders accept a smaller percentage in exchange for a larger business. The proceeds are also a signal of credibility to customers and suppliers.
Example
A listed airline sells new shares after a downturn to strengthen its balance sheet. Existing shareholders are diluted, but the airline avoids a debt burden that could threaten its survival. The offering lowers the ratio of debt to equity and reassures lenders.
Example
A biotechnology firm raises $150,000,000 through a follow-on offering to run a final-stage trial. Investors accept dilution because a successful trial could make the shares much more valuable. The cash is expected to last until the trial results are announced.
Formula
Calculation
Net proceeds = (New shares x Offer price) - Underwriting fees. Ownership after offering = Shares held / (Existing shares + New shares).
A company has 20,000,000 shares in issue and net income of $20,000,000, so earnings per share are $1.00. It sells 5,000,000 new shares at $12 in a primary offering. Gross proceeds are 5,000,000 x $12 = $60,000,000, and underwriting fees of 6% are $60,000,000 x 0.06 = $3,600,000, so net proceeds are $56,400,000.
A founder who held 10,000,000 shares owned 10,000,000 / 20,000,000 = 50% before the sale. Afterwards the company has 25,000,000 shares, so the founder owns 10,000,000 / 25,000,000 = 40%. If profit does not change straight away, earnings per share fall to $20,000,000 / 25,000,000 = $0.80 until the new money earns a return.Case study
Seen in the real world.
Summit Agritech is a fictional farm technology business that needed $40,000,000 to expand its production plant. Its board debated between a bank loan and a primary offering of new shares.
The illustrative analysis showed that the loan would add interest of about $3,000,000 a year and strict repayment dates, while the primary offering would dilute existing owners by around 12%. Because the sector was volatile, the board preferred the safer balance sheet that equity gave it.
The fictional offering was well received, and the company built the plant. The chief executive noted that dilution was a real cost, but the alternative of fixed debt payments during a downturn would have been riskier. The board also promised to report each quarter on how the proceeds were being spent.
Watch out
Common mistakes.
- Assuming all the money raised goes to the company, when fees and costs reduce the net amount. Plan spending using the net proceeds.
- Overlooking dilution, which reduces both ownership percentages and earnings per share. Calculate both before approving the sale.
- Confusing a primary offering with a secondary offering, where the company receives no cash. The prospectus states which type the offering is.
Questions
People also ask.
Why do share prices often fall when a primary offering is announced?
Investors expect dilution and may see the sale as a signal that management thinks the shares are richly priced.
Is an IPO a primary offering?
It can be, if new shares are sold and the company receives the money, though many IPOs also include shares sold by existing holders. The prospectus breaks down the split.
How does a primary offering differ from borrowing?
It adds owners and no repayment obligation, while borrowing adds debt with interest and a repayment date.
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