The benefits of issuing common stock
/There are a number of benefits associated with the issuing additional shares of common stock. These benefits vary for companies that are publicly held and privately held. For both privately and publicly held companies, the following advantages apply:
Advantage 1. Debt Reduction
The funds a company receives from its sale of common stock does not have to be repaid, and there is no interest expense associated with it. Thus, if a company currently has a high debt load, it can issue common stock and use the proceeds to pay down its debt. By doing so, the company reduces its fixed costs (since interest expense has been reduced or eliminated), which makes it easier to earn a profit at lower sales levels.
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Advantage 2. Enhanced Liquidity
If company management believes that the business requires cash to see it through future down cycles in the economy, or other issues that will constrain its cash flow, issuing common stock is one potential source of the needed cash.
Advantage 3. Founder Liquidity
When the common stock being sold belongs to the founders, a major advantage for them is that they can pocket the proceeds. This may represent the culmination of quite a lengthy process of building up the company, and may allow the founder to exit the business and retire. There is no direct advantage to the company in this case, since it is not receiving any funds from the transaction.
Advantage 4. Common Stock Issuances by Public Companies
For publicly held companies, the following additional benefits associated with issuing common stock also apply:
Easier acquisitions. A public company can issue common stock to the shareholders of acquisition targets, which they can then sell for cash. This approach is also possible for private companies, but the recipients of those shares will have a much more difficult time selling their shares.
Improved credit rating. A public company may have paid an independent credit rating agency to assign credit ratings to its securities. If the company has obtained a large amount of cash from stock sales, it will appear more financially conservative, and so the agency is more likely to assign a better credit rating.
Improved float. A public company will attract more investors if it has a large pool of registered shares available that they can buy and sell. By issuing more common stock and having those shares registered with the Securities and Exchange Commission, the float increases. However, if you issue shares that are not registered, then they cannot be sold, and the float is not increased.
Problems with Issuing Common Stock
Offsetting these numerous benefits are a few concerns with issuing common stock, which are as follows:
Ownership dilution. When a company issues new common stock, existing shareholders' ownership percentage decreases, reducing their control over the company. This can lead to conflicts, especially if major shareholders feel their influence is being weakened. Over time, excessive dilution can discourage investors from holding the stock.
Reduced earnings per share (EPS). Issuing more common stock increases the number of shares outstanding, which lowers earnings per share (EPS) if profits remain constant. A lower EPS can make the stock less attractive to investors, potentially driving down the stock price. This can also negatively impact key financial ratios that investors use to evaluate the company.
Market perception. If investors believe that issuing new stock signals financial weakness, they may lose confidence in the company, leading to a drop in stock price. This perception can arise if the company is raising capital due to cash flow problems rather than growth opportunities. A falling stock price can make future financing efforts more difficult and expensive.
Higher cost of capital. Raising money through common stock can be more expensive than borrowing debt, especially if the company is profitable. Unlike debt, where interest payments are tax-deductible, dividends paid on common stock are not tax-deductible, increasing the effective cost. Additionally, investors may demand higher returns, making equity financing less cost-effective.
Pressure to meet shareholder expectations. Common stockholders expect the company to consistently grow profits and possibly pay dividends, putting pressure on management to deliver strong financial results. This may lead to short-term decision-making that prioritizes stock performance over long-term business growth. In some cases, companies may take on excessive risks to satisfy investor demands.