Introduction
Most investors are familiar with an Initial Public Offering, or IPO. This is the exciting event when a private company first sells its shares to the public and becomes a publicly traded entity. However, an IPO is not the only time a company or its major shareholders can sell stock to the public. Sometimes, a company that is already trading on the stock market will decide to sell additional shares. This event is known as a secondary offering.
When a secondary offering is announced, it often makes financial headlines. You may also notice that the company’s stock price often drops in response to the news. This can be confusing for many investors. Why would a company selling more of its “product”—its stock—be a bad thing for the price? The answer lies in understanding what a secondary offering is and its potential impact on existing shareholders. This guide will clearly define this important corporate action. We will also explain the different types of offerings. Finally, we will cover why companies do them and what it means for you as an investor.
Defining the Secondary Offering: More Slices of the Pie
First, let’s establish a clear definition. A secondary offering, which is also known as a follow-on offering, is a process where a company that is already publicly traded sells additional shares of its stock to the public. Unlike an IPO, which is the very first sale of stock, a secondary offering is any subsequent sale. This process increases the number of shares that are available for trading on the market. This action can have a very important effect on the value of the shares that are already in the hands of investors.
To understand this, let’s return to our simple pizza analogy.
- Imagine a company is a large pizza that is cut into eight equal slices. You and seven other people each own one slice, or one share.
- The company decides that it needs to raise more money to grow. To do this, it creates two brand new slices of pizza from scratch and sells them to two new investors.
- Now, there are a total of ten slices of the same pizza. The size of the overall pizza has not changed.
- Because the same pizza is now divided into more slices, your original slice now represents a smaller percentage of the total pie. This is a crucial concept in investing known as dilution.
The Two Types of Secondary Offerings
It is essential to understand that there are two very different types of secondary offerings. They have very different implications for the company and its shareholders.
1. Dilutive Secondary Offering
This is the most common type of secondary offering. It is also the one that most directly impacts existing shareholders. In a dilutive offering, the company creates brand new shares that did not exist before. It then sells these new shares to the public. The cash proceeds from this sale go directly to the company itself.
This type of offering is called “dilutive” because it increases the total number of a company’s outstanding shares. As a result, it reduces, or “dilutes,” the ownership percentage of each existing shareholder, just like in our pizza analogy. This dilution is the primary reason why a company’s stock price often falls, at least in the short term, when it announces this type of offering. Companies use this strategy to raise capital to fund major expansion projects, pay down debt, or finance a large acquisition.
2. Non-Dilutive Secondary Offering
In this type of offering, no new shares are created. Instead, a large, private shareholder decides to sell a large block of their own personal shares to the public. These selling shareholders are typically company founders, executives, or early-stage venture capitalists.
This type of offering is “non-dilutive” because the total number of the company’s outstanding shares does not change. The shares are simply being transferred from one large private owner to many new public owners. It is important to know that the proceeds from this sale go directly to the selling shareholder. The money does not go to the company itself. The motivation for this type of sale is typically that the founder or early investor wants to cash out some of their stake in the company to diversify their personal wealth.
How a Secondary Offering Impacts Investors
The announcement of a secondary offering can have both short-term and long-term effects on a stock’s price and its investors.
The most common and immediate reaction to a dilutive secondary offering is a drop in the stock price. The market instantly reacts to the fact that the ownership pie is being cut into more slices. This makes each existing slice slightly less valuable.
However, the long-term impact of a dilutive offering depends entirely on why the company is raising the money. This is the most important question for an investor to ask.
- A Positive Scenario: Imagine a successful biotechnology company raises $100 million in a secondary offering. It announces that it will use this money to fund the final, promising clinical trial for a potential blockbuster new drug. In this case, long-term investors might see the short-term dilution as a very smart investment in the company’s future. The potential future profits from the new drug could far outweigh the current dilutive effect.
- A Negative Scenario: Now, imagine a struggling retail company raises $100 million in a secondary offering. It announces that it will use the money to cover its ongoing operating losses and to pay down debt from a period of poor performance. In this case, investors might see the offering as a sign of distress. The company is diluting its existing shareholders just to stay afloat, not to fund exciting future growth.
Conclusion
In summary, a secondary offering is a common event in the life of a publicly traded company. It is the process of selling additional shares to the public after the company has already completed its Initial Public Offering.
The most important distinction for an investor to make is whether an offering is dilutive or non-dilutive. A dilutive offering means the company is creating new shares to raise cash for itself. A non-dilutive offering means a large, existing shareholder is simply selling their personal shares. When you see a headline about a secondary offering, you should not just react to the initial, often negative, price movement. Instead, you should always ask the most important question: Why is the company raising this money? By understanding the reason behind the offering, you can make a much more informed judgment about the company’s long-term prospects and what the action truly means for your investment.