There are two types of secondary, or “follow-on,” offerings.
The first type is a non-dilutive offering. There, a big chunk of existing investors sell much of their equity stakes in the company. It’s non-dilutive because the company is not issuing new shares. The cash in the transaction goes to the shareholders who are ready to realize the value of their investment. Often, it is early investors like a venture capital fund that is exiting its position; it invested early and navigated the company all the way to the stage of its life during which it is ripe for a public offering. Then, the venture firm is ready to take its likely massive gain on the investment through a secondary offering.
The second type of secondary offering is a dilutive one. Here, the company is issuing new shares to raise cash for the business. This dilutes the value of each individual share because the market capitalization (the equity value of the company according to the market) is now divided up by a higher number of shares. Sometimes, ahead of a dilutive offering, investors will sell the stock, putting even more pressure on the price.
Tesla (TSLA) - Get Report recently filed an 8K saying it plans to issue new shares to raise $5 billion. The reason is to strengthen the company’s balance sheet. Tesla’s balance sheet is in pretty good shape — far better than in years past— but the company is still in aggressive investment mode, as it is looking to remain the leader in the explosively growing global electric vehicle market. Tesla is taking advantage of a flying share price, up almost 500% for the year. So why not raise cash now if it wants to pad its balance sheet for investments down the line?
Well, the stock fell 4.6% to $475 September 1 from $498 the prior day, the day before the announcement.
Often, dilutive share offerings are done by still-growing and unprofitable companies which may have raised a lot of money through their IPO’s. But if profits do not come fast enough, companies need to raise more money and a follow-on offering is one way to do that.
However, Tesla is profitable, so it’s a slightly different situation.
Sometimes share dilution can be positively outweighed by the growth prospects the capital raise enables the company to tap into. In that scenario, the share price can rise.