How Does Additional Equity Financing Affect Existing Shareholders?

Additional equity financing increases the number of a company's outstanding shares. This dilutes ownership percentages and reduces the control shareholders have over company decision-making. It also can lead to potentially lower earnings per share (EPS) as well as share value.

Issuing new shares can lead to a stock selloff, particularly if the company is struggling financially. Additionally, in a way, it can also be more costly than debt financing.

However, there are cases when equity financing can be favorable, such as when the funds raised are used to pay off debt or improve the company and position it for greater growth. In addition, capital raised by issuing equity doesn't have to be paid back.

What Is Equity Financing?

Equity financing is the process of issuing and selling shares of stock to raise money. Investors who buy shares in 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 payments (usually cash) that a company makes to shareholders as a reward for investing in the company.

Corporations sell shares of stock to raise capital to fund their business. The funds can be used for any reason, such as to:

• Acquire 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 vs. 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—the principal—back to investors plus make periodic interest payments annually.

The money raised through equity issuance doesn't need to be paid back, and there are no interest payments. Dividend payments could be considered analogous to an interest payment to shareholders. However, companies are not required to pay them. They also can raise, lower, and eliminate them if they do pay them.

Bear in mind that even though a company doesn't have to pay back equity investments as it does debt, there are costs to equity financing. Typically, there can be legal and accounting fees. And there is the effective cost of the reduction in an investor's portion of the profit tied to giving up ownership.

How Additional Equity Financing Affects Existing Shareholders

Ownership Dilution

When companies issue additional shares, it increases the number of shares of common stock traded in the stock market. For existing investors, too many additional shares can lead to serious ownership dilution. This occurs because the additional shares reduce the ownership percentages held by existing shareholders. 

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 now owns 10 shares out of 200 shares outstanding). In other words, the investor's percentage of ownership has been diluted by the newly issued shares. 

Loss of Control

Existing shareholders whose ownership percentage is diluted can lose the control they may have had over company decision-making, previous to the issuance of additional shares. For many shareholders, this may not matter.

However, it can have a negative effect for those who built up their ownership in a company through equity purchases because it was important that they maintained a say in how the company was run.

Earnings-Per-Share Drop

Issuing additional shares via equity financing decreases a company's EPS. For example, 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 cents per share ($2 million/10 million shares).

When the company issues another 5,000,000 shares, the total outstanding share count increases 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 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 can lower EPS, at least temporarily.

Stock Price Change

Since EPS declines due to new equity financing, companies often find that their stock price declines 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, that would reduce or eliminate the interest expense it pays. That 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 the newly raised funds are intended to be used to invest in the company's future (such as by expanding operations or acquiring a company that increases a company's value) and lead to greater profitability in the long run, the company's stock price likely will rise.

Example of Equity Financing

On February 13, 2020, Tesla Inc. (TSLA) announced that the electric vehicle manufacturer would offer an additional 2.65 million equity shares.

The company stated that the funds would be used to improve its balance sheet and for general corporate purposes.

The net proceeds were expected to be nearly $2.3 billion (before expenses). Chief Executive Officer Elon Musk was expected to purchase up to $10 million in shares when the new shares are issued.

After the announcement, Tesla's share price dropped at first by as much as 6% but eventually closed 4.8% up at $804 per share.

The Bottom Line

Additional equity financing—that is, raising fresh capital by issuing and selling new shares—can affect existing shareholders in various ways.

Two primary ways are in ownership dilution and the corresponding loss of control over a company. In addition to that, EPS can decline due to a greater number of outstanding shares and the share price can also drop. Both of these usually are temporary, if a company is financially healthy, with good prospects for growth and success.