One of the most common ways for companies, especially startups to raise capital is to issue new shares. But what does this actually mean, and what happens when a company issues new shares?
In this article we will go over the reasons why companies issue new shares, and what are the implications for shareholders.
What does issuing new shares mean?
Issuing new shares means that the company will sell new shares to shareholders at a predetermined price, and therefore increase the number of shares outstanding. This is common for companies to access more capital, without taking debt.
In some cases, it is not a well-established company, and it might not even have any revenues at all. For that reason, creditors will not be willing to lend money to these businesses. So the only option for the company to raise capital is by issuing new shares and attracting investors.
Why do companies issue new shares?
While most of the time companies issue new shares to raise capital, that is not always the case. Here are the two main reasons why companies issue new shares:
- Raise capital
- Give employees stock options
When a company needs to raise capital and it is unable to get a loan or issue debt, in the form of bonds, its only option is to issue new shares in the business. This is common among early-stage companies, and in some companies that run into trouble and are unable to borrow money at attractive rates. While in startups and angel investments, issuing shares is the standard procedure, a well-established company issuing shares is often a very bad sign. When lenders do not even allow you to borrow money or demand extremely unfair conditions, that is often that the company will face financial hardships.
Give employees stock options
Some companies offer shares as a form of compensation to their employees, and in order to do so, they need to issue shares. This is very common among some of the largest companies in the world, and in some cases, the company will even buy back its own shares so it can give compensation to its employees.
The company may also award its employees restricted stock units or RSUs, which are similar to stock options but are restricted during a certain period of time.
When can companies issue new shares?
Companies can issue shares whenever they see fit, but depending on the company it might require the approval of the board of directors and the shareholders. Due to the importance of the decision the stakeholders, and owners of the business need to approve the decision to issue shares.
How it affects shareholders
When a company issues new shares it is always a piece of negative news, that is not well received by the shareholders. The reason is that when a company issues shares, it forcefully dilutes the current shareholders, which end up owning less of the business.
For older companies that have been in business for a long time, a share dilution is never a good sign, and it can lead some investors to sell their shares. Additionally, it can also prevent investors from buying shares in the future do the risk of being diluted.
Is it good when a company issues more shares?
While in some cases it can be positive because the company needs the capital to grow and expand the business, and without issuing shares it will not be able to continue growing, it still affects the shareholders who see their equity diluted. But for most companies in an early growth stage, share dilution is common.
A business with very little assets, that is losing money while trying to grow and expand, requires always additional capital. The only way to access capital is to raise it by issuing shares, even if it dilutes existing shareholders.
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