What is a Secondary Offering?
A secondary offering takes place in the secondary market in the years following an IPO. It may either involve sale of existing shares or issue of fresh shares, depending on parties involved in the transaction.
The secondary market is the market where investors trade stock that they already own, whereas the primary market is where investors can buy newly issued shares.
The key to understanding a secondary offering is to distinguish it from an initial public offering (IPO). An IPO involves the issue of fresh equity shares to fulfill a company’s capital requirements. Sometimes IPOs may have a secondary component where an existing investor, such as a venture capital firm or a promoter, offers their holdings for sale.
Types of secondary offerings
Secondary offerings may be classified based on dilution of ownership.
Non-dilutive secondary offerings
A non-dilutive secondary offering involves the sale of already issued equity shares by a major shareholder. It’s important to understand that the company has no role to play in a non-dilutive secondary offering. The company doesn’t receive cash nor issue any equity shares. The transaction is carried out between two entities, a buyer and a seller, in the secondary market.
A non-dilutive secondary offering generally happens after the post-IPO lock-up period ends. While this type of secondary offering has no impact on the total outstanding shares of the company, it could increase the float and consequently improve the stock’s liquidity.
Dilutive secondary offerings
A dilutive secondary offering is also known as a follow-on offering. It has some similarities to an IPO in that it involves the issue of new shares, and the company receives proceeds arising from the transaction.
A dilutive secondary offering increases the company’s capital, total outstanding shares, and float, consequently diluting the stake of current shareholders. The company may use the proceeds of the issue for reducing its debt, capital expenditure, working capital, or similar purposes.
The share price may drop following an announcement of a dilutive secondary offering because the earnings per share (EPS) will also be diluted post the offering. For instance, if the EPS is $2 before the offering, it may drop to $1 if the total issued shares double after the secondary offering.
A company may use one of the following methods for a dilutive secondary offering:
The company issues shares to institutional investors such as hedge funds and trusts or high-net-worth individuals. Retail investors can’t participate since a private placement is not open to the public. Therefore, the shares aren’t available for purchase in the primary market.
The company, much like in an IPO, issues new shares to the public. The company hires an investment bank to underwrite the issue, and the investment bank takes care of everything from marketing the issue to registering it with the Securities and Exchange Commission (SEC). Unlike a private placement, retail investors can participate in a public offering.
The company issues its new shares to institutional investors at a price significantly below the market price. The investors sell those shares in the open market for a huge profit. The increased supply of shares puts downward pressure on the price, so other investors who bought the shares at a much higher price are adversely impacted.
Example of a secondary offering
In 2000 Goldman Sachs Group Inc. filed a secondary offering of 40M shares with the SEC, which meant the float would increase to 27% after the offering.
Investors selling their shares included Sumitomo Bank Capital Markets Inc., Kamehameha Activities Association, and former partners.
The shares were sold for $99.75 each, about $1 below its previous closing price. The total value of the offering was about $4B, making it one of the biggest secondary offerings on Wall Street at the time.
A secondary offering gives companies and major shareholders an opportunity to realize the gain on their investments, but it can negatively impact small investors and traders.
A non-dilutive secondary investment, though doesn’t directly affect the stock’s market price, may cause investor sentiment to turn sour, effectively driving the stock’s price down. However, a dilutive secondary offering will almost always drive the stock’s price down since it will reduce the company’s EPS.
As investors, you should be wary of secondary offerings. If possible, try to predict if a company you have invested in or are planning to invest in will make a secondary offering in the foreseeable future, and liquidate the investment or avoid investing.