How Does Additional Equity Financing Affect Existing Shareholders?

Additional equity financing increases the number of outstanding shares for a company. The result can dilute the value of the stock for existing shareholders. Issuing new shares can lead to a stock selloff, particularly if the company is struggling financially. However, there are cases when equity financing can be seen as favorable, such as when the funds are used to pay off debt or improve the company.

Understanding Additional Equity Financing

Equity financing is basically the process of issuing and selling shares of stock to raise money. Investors who buy shares of a company become shareholders and can earn investment gains if the stock price rises in value or if the company pays a dividend. Dividends are typically cash payments as a reward to shareholders for investing in the company.

Corporations issue or sell shares of stock to raise capital to fund the business. The funds can be used to:

• Buy a company, such as a competitor or supplier
• Build a new manufacturing facility
• Expand into a new product line
• Pay down or pay off outstanding long-term debt

Equity financing allows companies to raise large sums of money without having to borrow money from banks or issue bonds. Since banks charge an interest rate on loans, equity financing saves a company the interest expense of borrowing.

Bonds are also sold to investors to raise cash, but the company must pay the original amount–called the principal–back to investors as well as periodic interest payments. The money raised through equity issuance doesn't need to be paid back, and there are no interest payments. Although, dividend payments could be considered analogous to an interest payment to shareholders. However, companies are not required to pay them. They can also raise, lower, and cancel them if they do.

How Equity Financing Affects Existing Shareholders

Many investors do not like when companies issue additional shares for equity financing. Investors often feel that their existing ownership has been diluted or watered down, and in some cases, can lead to investors selling the stock altogether.

Share Dilution

When companies issue additional shares, it increases the number of common stock being traded in the stock market. For existing investors, too many shares being issued can lead to share dilution. Share dilution occurs because the additional shares reduce the value of the existing shares for investors. 

For example, let's say a company has 100 shares outstanding, and an investor owns ten shares or 10% of the company's stock. If the company issues 100 additional new shares, the investor now has 5% ownership of the company's stock since the investor owns 10 shares out of 200. In other words, the investor's holdings have been diluted by the newly issued shares. 

Earnings-Per-Share Impact

Issuing additional shares via equity financing decreases a company's earnings-per-share (EPS). For example, let's say a company needs to raise money, so it decides to issue an additional 5,000,000 shares to be sold in the market.

If the company initially had 10,000,000 shares outstanding and recorded a profit of $2,000,000, the company would have an EPS of .20 or 20 cents per share ($2 million/ 10 million shares).

When the company issues another 5,000,000 shares, the total outstanding share count will increase to 15,000,000. The company's revenue and earnings (profit) have not changed in value. However, the company's EPS would decline to .13 or 13 cents per share ($2 million / 15 million shares).

Since EPS is a closely watched metric that company executives, investors, and analysts use to forecast a company's expected profitability, any change in EPS is noteworthy. As a result, additional equity financing can carry a negative connotation in the markets since it lowers EPS.

Stock Price Impact

Since EPS declines from new equity financing, companies often find their stock price decline initially. However, new equity financing is not always a bad decision by a company's executive management team. If a company is using the funds to pay down debt, which would reduce or eliminate the interest expense from the debt, it can be seen as a good sign and lead to a rising stock price.

Of course, companies that are struggling to remain financially solvent might issue additional shares as a last ditch effort to remain in business. In this situation, the stock price seldom rises, particularly if the company has been in an ongoing downward spiral.

However, companies that are early-stage growth companies with an optimistic investor base might see an increase in the company's share price from additional equity financing. If investors believe that the funds from the new issuance will be used to invest in the company's future, leading to an increase in profits in the long run, the company's stock price might rise.

Real World Example of Equity Financing

An example of additional equity financing is Tesla Inc. (TSLA). The electric vehicle manufacturer announced on February 13, 2020, through its filing with the SEC that the company will be offering an additional 2.65 million equity shares.

The company stated that the funds will be used to improve its balance sheet and for general corporate purposes. The net proceeds are expected to be nearly $2.3 billion based on Tesla's stock price of $767.29 per share as of February 12, 2020. Chief Executive Officer Elon Musk is expected to purchase up to $10 million in shares when the new shares are issued.