I’ve previously written about how Capital Raises (CRs) can actually be a good thing, whether you’re investing or not. Today I wanted to talk about how a CR can dilute share price, specifically for ailing companies.
After a CR, value in shareholdings for existing shareholders could be argued to be what it’s worth pre CR because even though the shares are are smaller percentage of the company value, those shares are also worth an equal fraction of the value of the money generated from the CR. In the case of well used funds, a CR can add increasing long term value to a company as that capital funds growth. In the case of an ailing company that is doing a CR to raise money to stay afloat, that money will be gone within a while (typically a year). In this case, the ailing company could be said to be worth what is was worth pre CR, but all shareholdings held before the CR would be diluted by any new shares issued, therefore lowering the share price.
For an analogy, consider a chocolate cake that is cut into 4 pieces and costs you $5 a slice. You buy a 1 slice (a quarter) of the cake for $5. The cake shop needs more money, so they cut all the slices in half (including the slice you bought). You now have to buy another slice to maintain the same amount of cake (1 quarter). You’ve now paid a total of $10, you own 2 slices, which is still the same amount of cake as you had originally.