🏦 Why companies sell shares: IPOs, listings and dilution

🎯 In 30 seconds: Companies sell shares to raise money they never have to pay back. The first public sale is usually an IPO (initial public offering). After that, the shares trade between investors on an exchange, and the company gets nothing from those trades. When a company creates new shares later, each existing share owns a smaller slice. That is dilution, and it is one of the quiet ways shareholders lose value.

Why a business needs outside money

Every growing business hits the same wall. It wants to build a factory, hire engineers or open in a new city, and the profits it makes today are not enough to pay for it.

It has two main ways to get the money:

• Borrow it (debt). Take a bank loan or sell bonds. The company keeps full ownership, but it must pay interest and repay the loan on schedule, even in a bad year.
• Sell ownership (equity). Sell shares to investors. The company never has to pay that money back and owes no interest. The price is that the founders now share the profits and the votes with new owners.

Young companies with no steady profits often cannot borrow much, so equity is their main fuel. Mature companies with stable cash flow tend to borrow more because debt is cheaper than giving away ownership.

From garage to stock exchange

Most companies sell shares many times before the public ever sees them. A typical path looks like this:

1. Founders. The people who start the company own 100% of it.
2. Friends, family and angel investors. Early backers buy a slice of the company, usually for a fairly small amount of money.
3. Venture capital. Professional funds buy larger slices in rounds (Series A, B, C) as the company grows.
4. Going public. The company sells shares to anyone through an IPO, a direct listing or a merger with a SPAC. Its shares then trade on an exchange.

Going public gives the company access to a much bigger pool of money. It also gives early investors and employees a way to sell their shares, which is called liquidity. In return, the company must publish detailed financial reports every quarter and follow SEC disclosure rules for as long as it stays public.

Primary market vs secondary market

This is the single most important idea in the chapter, and many beginners get it wrong.

The primary market is where a company sells brand new shares and receives the cash. An IPO is a primary market sale.

The secondary market is where investors trade existing shares with each other. When you buy 10 shares on your broker's app, you almost always buy them from another investor, not from the company. The company does not receive a cent from that trade.

So why does a company care about its share price after the IPO? Because a higher price makes it cheaper to raise money again later, lets it use shares to buy other companies, and makes the stock it pays employees worth more. Executives are also usually large shareholders themselves.

How an IPO works, step by step

1. Hire underwriters. Underwriters are investment banks that manage the sale. They help set the price, find buyers and are paid a fee taken out of the money raised.
2. File a registration statement. The company files with the SEC, usually on Form S-1. The key part is the prospectus: a long document describing the business, its finances, its risks, who owns what and how the money will be used.
3. SEC review. SEC staff review the filing and send comments. When they are satisfied, the registration is declared effective. This is not an approval of the investment. The SEC does not judge whether the company is a good buy.
4. The roadshow. Executives and bankers pitch the company to large investors such as mutual funds and pension funds. The underwriters collect "indications of interest": how many shares each investor would want, and at what price.
5. Pricing. The night before trading starts, the company and underwriters set the final IPO price, using that demand.
6. Allocation. The shares go mostly to the institutions that put in orders. Some brokers give individual customers access to a small number of IPO shares, often with eligibility rules.
7. First trade. The next morning the exchange runs an opening process, and the stock starts trading on the secondary market. The first trade can be far above or below the IPO price.

Most IPOs also come with a lock-up agreement: insiders such as founders, employees and early investors agree not to sell for a set period. Terms vary, but most last 180 days. When a lock-up ends, a large number of shares can suddenly become sellable, and the price sometimes drops around that date.

Two other ways to go public

Direct listing. The company lists its existing shares on an exchange without underwriters running a traditional IPO. There is no roadshow allocation and usually no lock-up. The opening price is set by an auction on the exchange, matching real buy and sell orders. Originally only existing shareholders could sell. NYSE rules now also allow a company to sell new shares in the opening auction, with minimum size requirements, so a direct listing can raise money too.

SPAC (special purpose acquisition company). A SPAC is a shell company with no business. It raises money in its own IPO, puts the cash in a trust account, and then has a limited time, typically two years, to find a private company to merge with. When the merger (the "de-SPAC") happens, the private company becomes public.

SPAC investors can usually ask for their money back from the trust instead of staying in after the merger. The catch is in the details. The sponsors who create the SPAC often get a large block of shares for a nominal price, and SPAC units often include warrants, rights to buy more shares later at a set price. Both add shares, which dilutes everyone else. In January 2024 the SEC adopted rules requiring more disclosure about sponsor pay, conflicts of interest and dilution in SPAC deals.

Share count: the number that changes your slice

Your ownership is your shares divided by shares outstanding, which is every share the company has issued and not bought back. If shares outstanding grow, your slice shrinks, even though you did nothing.

That shrinking is dilution. It is not automatically bad. If the company raises money and uses it to earn a high return, the whole pie can grow faster than your slice shrinks. If the money is wasted, or shares are handed out without bringing in much value, you lose.

A worked dilution example

Hypothetical numbers. Company X has 10 million shares outstanding, trades at $40 and earns $20 million a year. You own 10,000 shares.

EPS fell 16.7% overnight. For EPS to get back to $2.00, total earnings must reach $24 million. That means the $80 million has to produce $4 million a year of extra profit, a 5% return on the new money. If the company spends it on something that earns 15%, shareholders come out ahead. If it earns 0%, they are worse off.

Where new shares come from after the IPO

• Follow-on offerings. The company sells another batch of shares to the public. Announcements often push the price down that day.
• At-the-market (ATM) programs. The company quietly sells shares into the market a little at a time. Common at small, cash-hungry companies.
• Stock-based compensation. Employees are paid partly in shares or options. This is normal at tech companies, but a share count that rises a few percent every year adds up.
• Convertible bonds and warrants. Securities that can turn into shares later, usually when the price rises.
• Acquisitions paid in stock. The company issues shares to the owners of the business it buys.

The opposite is a buyback: the company uses cash to buy its own shares on the secondary market and retire them, which raises each remaining share's slice. See Dividends, splits and buybacks.

What this means for a trader

• Recent IPOs tend to have small floats, little price history and big swings. Size positions smaller, and know the lock-up date.
• Offering announcements and ATM filings are common reasons a small stock drops sharply. Read the news before blaming the chart.
• Price targets and P/E ratios depend on the share count. A stale share count makes every per-share number wrong. You will use this in Valuation ratios and Measuring business quality.

Try it

Pick any company that went public in the last five years. On SEC EDGAR (see Where to get reliable market information), find its S-1 and note the shares outstanding after the IPO. Then open its latest 10-Q and note the current number. Work out the average yearly change. Add the stock to your Watchlist with a note of that number, and repeat the check every quarter.

Sources

• Investor.gov (SEC): Investor Bulletin, Investing in an IPO
• Investor.gov (SEC): Initial public offerings, lockup agreements
• NYSE: Direct listings
• Investor.gov (SEC): What you need to know about SPACs, updated investor bulletin
• SEC: SEC adopts rules to enhance investor protections relating to SPACs (January 24, 2024)