When a public company increases the number of shares issued, or shares outstanding, through a secondary offering,it generally has a negative effect on a stock's price and original investors' sentiment.
Going Public
First, acompany goes public with aninitial public offering(IPO) of stock. For example, XYZ Inc. has a successful IPO and raises $1 million by issuing 100,000 shares. These are purchased by a few dozen investors who are now the owners, or 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. So, 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.
The Secondary Offering and Dilution
Subsequently, things are looking up for XYZ, which prompts management to raise more equity capital through a secondary offering in order to secure the necessary capital for operations. That secondary offering is successful. In this instance, the company only issues 50,000 shares, which produces additional equity of $50,000. 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, when viewed from theoriginal investors' perspective—those who became shareholders through the IPO—with the increase in the shareholder base, their level of ownership has been decreased. This consequence is referred to as the dilution of their ownership percentage.
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%.
How Investor Sentiment Is Affected
While an absolute increase in a company's net income is a welcome event, 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 those earnings 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. And the prospect of share dilution will generally hurt a company's stock price. That said, there are ways original investors could possibly protect themselves against dilution, for example, with contractual provisions that restrict a company's power to reduce an investor's stake after laterfunding roundsoccur.
The Bottom Line
While IPOs are very exciting, they may not always be the best way for an investor to increase their stock market wealth. When researching investment opportunities, always pay attention to capitalization and dilution potential, and keep your eye on a company's EPS.
FAQs
The price of stocks can also decrease during a secondary offering because the company issues the offered shares at a discounted price to incentivize investors to buy. The decrease in value can last a while because any investors who buy-in at the discounted price can sell at a slight increase and make a profit.
What does a secondary offering do to stock prices? ›
When a public company increases the number of shares issued, or shares outstanding, through a secondary offering, it generally has a negative effect on a stock's price and original investors' sentiment.
What are secondary shares in a company? ›
While primary shares are all about new stock issued by the company, secondary shares involve the sale of existing stock held by current shareholders, like founders, employees, or investors. These sales do not inject new capital into the company but provide liquidity to the sellers.
What is the difference between a primary and secondary offering? ›
Primary offerings enable companies and funds to raise capital by issuing securities to investors, while secondary trading allows for liquidity and exit options for existing shareholders through trading already issued securities.
What is the difference between an IPO and a secondary offering? ›
Initial public offerings (IPOs) occur when a company sells shares on listed exchanges for the first time. Secondary or follow-on offerings allow firms to raise additional capital at a later date after the IPO has been completed, which may dilute existing shareholders.
What are the advantages of secondary offering? ›
A company generally uses the Follow-On Public Offering as a means to raise additional funds to meet its capital demands. The benefits of secondary offerings include easier liquidity for shareholders, expanding the investor base, and price stabilisation.
What are the effects of secondary offerings? ›
Secondary offers can impact the price of a company's shares and investor sentiment. For instance, investors could expect negative news if a large shareholder sells off a sizable portion of their shares. Furthermore, the secondary offerings that dilute share price usually witness price drops.
How do I sell secondary shares? ›
How to sell shares of a private company on a secondary market
- You choose an online platform.
- You set the price and quantity of shares you want to sell.
- A broker gets assigned to you.
- Your broker tries to match you with a buyer.
- If you find a buyer, you seek approval from your company.
Follow-on offerings allow companies to raise additional capital, increase their market exposure, and enhance their reputation among investors. However, they also carry risks, such as diluting existing shareholders' ownership, over-saturating the market with shares, and the risk of underpricing the offering.
What is an example of a secondary stock? ›
The secondary market is where investors buy and sell securities from other investors (think of stock exchanges). For example, if you want to buy Apple stock, you would purchase the stock from investors who already own the stock rather than Apple. Apple would not be involved in the transaction.
As mentioned above, securities sold in a secondary offering are held by investors and sold to one or more other investors through a stock exchange. As such, the proceeds from a secondary offering go directly to the seller—not the company whose shares change hands.
What is a secondary offering in private equity? ›
A private equity secondary is a trade in which an investor purchases an asset from another investor. Private equity primary investments are transactions made by investors (either directly or via a fund) where a stake in a private company is acquired.
What is the difference between a follow on equity offering and a secondary offering? ›
A follow-on public offer (FPO) is an issuance of additional shares by a public company that is already listed on an exchange. A secondary offering is the sale of new or closely held shares of a company that has already made an initial public offering (IPO).
Does a secondary offering increase shares outstanding? ›
A dilutive secondary offering increases the company's capital, total outstanding shares, and float, consequently diluting the stake of current shareholders.
What does an offering do to a stock? ›
A securities offering, whether an IPO or otherwise, represents a singular investment or funding round. Unlike other rounds (such as seed rounds or angel rounds), however, an offering involves selling stocks, bonds, or other securities to investors to generate capital.
What is secondary sale of shares? ›
What is a "secondary sale"? A secondary sale is a sale by an existing stockholder to a third-party purchaser, the proceeds of which benefit the selling stockholder. This is in contrast to a "primary" issuance, in which the company is selling its stock to an investor and using the proceeds for corporate purposes.
How does secondary listing affect stock price? ›
In terms of stock pricing, the pricing of the secondary listing is basically the same as that of the original market, and the stocks in different places of listing can be exchanged with each other.
Can a stock go up after an offering? ›
The exact reason for an increasing stock price following a secondary offering may not always be apparent. Sometimes, investors respond favorably to the offering if it's believed that the proceeds from the sale may help the company.
What happens to stock price after offering? ›
The company completes the offering at an attractive price and the shares are quickly absorbed by the market. In fishing terms, the market “inhales” the new shares. And the stock's trend continues, more or less as it had been prior to the secondary offering.
Why does stock price drop after offering? ›
The issuance of new shares represents an increase in the supply of shares to the market. Therefore, the price will decline if the demand for an individual stock is not perfectly elastic, and the decline should be greater for a larger issue.
