Investors always cringe at the announcement of a capital raise and the mind immediately triggers thoughts of dilution, but capital raises aren’t always bad. In fact, sometimes they can be a good thing – even dilution can be a good thing.
What Is A Capital Raise?
First of, lets start with the question What is a capital raise? A capital raise is where a company creates some new shares (although theoretically these could instead come from any treasury of shares, if the company holds any), then sells those shares to raise more capital. Typically the company constitution will stipulate that existing shareholders have first dibs on the opportunity to buy a proportion of these shares relative to their existing holding so the overall percentage of the company they own is not diluted – though this is not always the case, particularly with listed companies.
Why Do Companies Do Capital Raises?
The answer to this question holds the answer to the statement in the title of this article – that capital raises can be a good thing.
There are two main reasons companies do capital raises:
- Because they foresee themselves struggling to make ends meet and need a cash injection to keep the company running.
- Because they are raising money for inorganic growth.
Counter-intuitively, either of these two reasons can be good or bad for an investor.
The Benefits Of Capital Raises For Investors In Ailing Companies
Almost always it’s bad if a company is approaching shareholders, begging for money to make ends meet. It means that the company is not performant, which is bad for the outlook of the company. However, such capital raises are always done at a discount to the current share price (otherwise nobody would by the shares), and herein lies the opportunity for a shareholder to glean value. Share traders might take advantage of a below market value capital raise if they think they can sell the shares on the market for more, after the capital raise. This typically causes the share price to gradually drop to be equal to the value of the capital raise as shareholders sell at a profit.
Long term investors may also see such a capital raise as a benefit, but only on shares of companies that have longer term prospects and if they are able to take a larger percentage holding than they previously held. In this scenario, an investor might find the capital raise has value to them by calculating the future value of shares, minus future dilutions and opportunity cost each year before expected return to profitability (or whatever other position the investor wishes to exit). If the shares are cheap enough to be below the calculated value then a purchase might be favorable if they are able to take up a holding larger than their existing percentage holding in the company. There are also some odd scenarios whereby an investor may welcome dilution, for example if new investors are getting a bad deal and the dilution works up the value of the company (because there’s more money in the coffers or other reasons).
The Benefits Of Capital Raises For Investors In Companies Seeking Capital For Growth
Oddly, this one can also be good or bad – and this centers around how successfully the newly raised capital can be turned into growth, and of course the valuation. If the new shares are sold for less than the value of the growth they will add, a capital raise can be seen as a good thing for those participating – even if they get diluted, the overall value of the portfolio (diluted stocks plus new stock held) will be worth more than the investors position before the capital raise (undiluted stocks + cash).
Additionally, a capital raise can be good if the valuation is too high, and an existing stockholder accepts the dilution. In this scenario, the new investors pay for the growth, and the existing shareholders get diluted then the value of their stock increases beyond the pre-dilution value.
In summary, capital raises can be good or bad, depending on what they’re for, the valuation of the new stock and how the investor reacts to the capital raise.