Companies undertake major changes as they grow, evolve, mature, or merge with another company. Some of these changes result in changes to the number of common shares outstanding-the number of common shares currently held by shareholders.
Various corporate actions can affect equity outstanding:
Selling shares to the public for the first time (when a private company becomes a public company), referred to as an initial public offering (IPO)
Selling shares to the public in an offering subsequent to the initial public offering, referred to as a seasoned equity offering or secondary equity offering
Buying back existing shares from shareholders, referred to as a share repurchase or share buyback
Issuing a stock dividend or conducting a stock split
Issuing new stock after the exercise of warrants
Issuing new stock to finance an acquisition
Creating a new company from a subsidiary in a process referred to as a spinoff
12.2 Initial Public Offering
The main difference between a private company and a publicly traded company is that the shares of a private company are available only to select investors and are not traded on a public market. A private company becomes a publicly traded company through an IPO, which is the first time that it sells new shares to investors in a public market.
Private companies become publicly traded companies for a number of reasons. First, it gives the company more visibility, which makes it easier to raise capital to fund growth opportunities. It also helps attract talented staff, raise brand awareness, and gain credibility with trading partners. In addition, it provides greater liquidity for shareholders who want to sell their shares or buy additional shares. At or after the IPO, some of the original shareholders may choose to sell some of their shares. The fact that the shares now trade in a public market makes the shares more liquid and thus easier to sell. A disadvantage to becoming a public company is increased regulatory and disclosure requirements. IPOs are also expensive; their cost can be as much as 10% of the proceeds.
Example: XYZ Limited, an Indian company founded in 2008, announced its intention to become a publicly traded company. The shares were to trade on both the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). The company raised Rs.7,800crs, but had to pay transaction costs of Rs.546crs million (about 7% of the entire proceeds of the IPO).
12.3 Seasoned Equity Offering
After an IPO, publicly traded companies may sell additional shares to raise more capital. The selling of new shares by a publicly traded company after an IPO is referred to as a seasoned or secondary equity offering. A seasoned equity offering typically has far lower costs associated with it compared with an IPO. A typical seasoned equity offering increases the number of shares outstanding by 5%-20%. For an existing investor who does not buy additional shares in the seasoned equity offering, the increase in shares outstanding dilutes the investor's ownership percentage.
Example: Assume a company X that has traded publicly since 2000, announced it would sell additional shares to the public in a seasoned equity offering. Accordingly 547.8crs shares were issued at Rs.22.25 share (= Rs.12,189crs = 547.8crs-22.25). If the net proceeds that the company records in its books is Rs.12,006crs, then issuance costs is Rs. 183crs (= Rs.12,189crs -Rs.12,006crs, less than 2% of the proceeds). The issuance costs for this seasoned offering are much lower than the costs of the IPO.
12.4 Share Repurchases
Companies may choose to return cash to shareholders by repurchasing shares rather than paying dividends. Assuming that the company's net income is unaffected by the repurchase, the share repurchase will increase the company's earnings per share because net income will be divided by a smaller number of shares. Repurchased shares are either cancelled or kept and reported as treasury stock in the shareholders' equity account on the company's balance sheet. Treasury shares are not included in the number of shares outstanding. To buy back shares, a company can buy shares on the open market just like other investors or it can make a formal offer for repurchase directly to shareholders. Shareholders may choose to sell their shares or to remain invested in the company. For an existing investor who does not sell shares, the decrease in the number of shares outstanding effectively increases that investor's ownership percentage
Example: A company with 2 million common shares outstanding and a current stock price of Rs.50 wants to distribute 1 million to its shareholders. The company could pay a dividend of 0.50 paise per share (1 million/2 million shares) or buy back 20,000 shares from shareholders willing to sell their shares (20,000 shares x 50 = Rs10,00,000), assuming that the company can buy the shares at their current market value. After the repurchase, the number of shares outstanding would decrease to 1.98million (2 million - 20,000).
12.5 Stock Splits and Stock Dividends
Companies may, on occasion, conduct stock splits or issue stock dividends. A stock split is when a company replaces one existing common share with a specified number of common shares. A stock dividend is a dividend in which a company distributes additional shares to its common shareholders. Stock splits and stock dividends both increase the number of shares outstanding, but they do not change any single shareholder's proportion of ownership.
When a company splits its stock or issues a stock dividend, the number of shares outstanding increases and additional shares are issued proportionally to existing shareholders based on their current ownership percentages. The overall value of the company should not change, so the price of each share should decrease. But the value of any single shareholder's total shares should not change in value. Lets understand the effect of stock spilt and stock dividend through an example.
Example: A company has 24,000 shares outstanding and each share trades at Rs.75. An investor owns 900 shares.
Stock Split- The company announces a three-for-two stock split. This means for every two shares the investor currently owns, she will receive three shares in replacement. So, she will have 1,350 shares after the stock split. (900/2) x 3 = 1,350 shares
Stock Dividend- The company declares a 50% stock dividend-that is, for every share the investor currently owns, she will receive an additional 0.5 shares. In other words, she will have 1,350 shares. 900 x 1.5 = 1,350 shares
A stock split or stock dividend does not change each shareholder's proportional ownership of the company. Shareholders do not invest any additional money for the increased number of shares, and the stock split or stock dividend does not have any effect on the company's operations. The total value of the company's shares and an investor's shares are unchanged by the stock split or stock dividend.
Given that stock splits and stock dividends do not have any effect on company operations or value, why do you think companies take these actions? One explanation is that as a company does well and its assets and profits increase, the stock price is likely to increase. At some point, the stock price may get so high that shares become unaffordable to some investors and liquidity decreases. A stock split or stock dividend will have the effect of lowering a company's stock price, making the stock more affordable to investors, and thereby improving liquidity. It is important to note that the affordability of a company's stock is different from whether the stock is undervalued or overvalued. That is, a company with a stock price of Rs1000 per share may be unaffordable to some investors, but may still be considered undervalued when the price per share is compared with the estimated value per share. Similarly, a company with a stock price of Rs.5 per share may be affordable to most investors yet still be overvalued.
Companies with very low stock prices may conduct a reverse stock split to increase their stock price. In this case, the company reduces the number of shares outstanding. The primary reason for a reverse stock split is that a company may face the risk of having its shares delisted from a public exchange if its stock price falls below a minimum level dictated by the exchange.
After the reverse stock split, shareholders will still own the same proportion of the shares they originally owned. In other words, a reverse stock split reduces the number of shares outstanding but does not affect a shareholder's proportional ownership of the company. After a reverse stock split, the stock price should increase by the same multiple as the reverse stock split.
12.6 Exercise of Warrants
Companies that issue warrants as a form of additional or bonus compensation to employees may have to increase shares outstanding if the warrants are exercised. If an investor exercises warrants, the issuing company's number of shares outstanding increases and all other existing shareholders of the company's stock will see their ownership percentage decrease. Given that there may be numerous employees who exercise warrants on a recurring basis, companies that issue warrants to employees as a form of compensation will typically experience an increase in shares outstanding every year. To mitigate the dilution effect on existing shareholders, these companies may repurchase a small amount of shares each year to offset the additional shares issued when warrants are exercised.
One company may acquire another by agreeing to buy all of its shares outstanding. All of the outstanding shares of the acquired company are redeemed for cash, for stock in the acquiring company, or for a combination of cash and stock of the acquiring company. Shareholders of the acquiring company and the target company (the company to be acquired) are typically asked to vote on a proposed acquisition. If the company being acquired is small and the acquirer has sufficient cash, there is no need to issue new shares. For larger acquisitions, the acquiring company may pay for the purchase by issuing new shares. The amount of new shares issued depends on the purchase price and the ratio of the two companies' stock prices. An acquisition in which the company uses its stock to finance the transaction results in an increase in the acquiring company's shares outstanding. For existing shareholders in the acquiring company, the increased shares outstanding effectively dilutes their ownership percentage.
A company may create a new company from an existing subsidiary in a process referred to as a spinoff. Shares of the new entity are distributed to the parent company's existing shareholders. After the spinoff, the value of the shares of the parent company initially declines as the assets of the parent company are reduced by the amount allocated to the new company. But shareholders receive the shares of the newly formed company to compensate them for the decrease in value.
A company's management may conduct a spinoff in an effort to create value for its shareholders by splitting the company into two separate businesses. The rationale behind a spinoff is that the market may assign a higher valuation to two separate but more specialized companies compared with the value assigned to these entities when they were part of the parent company.