Stocks are a vital part of the financial world, and many people invest in them to grow their wealth. But how does a corporation make money from the stocks it offers to the public? It’s a common question, and understanding the process can help investors better grasp the dynamics behind the stock market. In this article, we’ll explore how companies raise money through stocks in a simple and easy-to-understand way.
What Are Stocks?
Stocks represent ownership in a company. When a person buys a stock, they are purchasing a small portion of that business. This is why shareholders are sometimes called part-owners. Stocks are traded in the stock market, where individuals and institutions can buy and sell them.
Types of Stocks
Before diving into how corporations make money from stocks, it’s important to understand that there are two main types of stocks:
Common Stock: The most common type of stock, giving shareholders voting rights and the potential to receive dividends (a portion of the company’s profits).
Preferred Stock: Stock that typically does not come with voting rights but gives priority to dividends.
Now that we know what stocks are, let’s see how companies benefit from issuing them.
Initial Public Offering (IPO)
The main way a corporation raises money from stocks is through an Initial Public Offering (IPO). An IPO is when a private company offers its shares to the public for the first time. This process transforms the company from a private entity to a public one.
Why Do Companies Go Public?
When a company decides to go public, it’s typically looking to raise a large amount of money. This money can be used for several purposes, such as:
- Expanding the business
- Paying off debts
- Developing new products
- Acquiring other companies
How Does an IPO Work?
Preparation: Before a company goes public, it prepares for months or even years. It hires investment banks and other professionals to guide the process.
Setting a Price: The company works with underwriters (usually investment banks) to determine the price of the stock and how many shares to offer. The price depends on factors such as the company’s valuation, market conditions, and investor demand.
Selling the Shares: Once the stock price is set, shares are sold to institutional investors (like banks and hedge funds) and sometimes retail investors (individuals like you and me). The company receives the money from this sale.
Raising Capital Through an IPO
The IPO is a one-time event that provides a huge influx of cash to the company. For example, if a company sells 1 million shares at $20 per share, it raises $20 million, minus the fees paid to underwriters and other professionals involved in the process.
Secondary Offerings
In addition to the IPO, companies can also raise money through secondary offerings. A secondary offering occurs when a company that is already publicly traded issues more shares to raise additional capital.
Types of Secondary Offerings
Dilutive Offering: This type of offering increases the total number of shares, which can dilute the value of existing shares. The company raises money by selling these additional shares.
Non-Dilutive Offering: In this case, existing shareholders, such as company insiders, sell their shares. The company doesn’t raise new money directly, but the shares are traded on the open market.
Why Do Companies Do Secondary Offerings?
Companies may choose to have a secondary offering to:
- Raise more money for growth
- Pay off debt
- Finance an acquisition Secondary offerings can sometimes make investors wary because issuing new shares can dilute the ownership percentage of existing shareholders.
Stock Buybacks and Dividends
While companies raise money by selling stock, they also return money to shareholders through stock buybacks and dividends.
Stock Buybacks
A stock buyback occurs when a company purchases its own shares from the stock market. This reduces the number of shares available, often leading to an increase in the stock price. While a buyback doesn’t raise new money for the company, it can signal to investors that the company is confident in its future, making the remaining shares more valuable.
Dividends
Some companies pay dividends to their shareholders. A dividend is a portion of the company’s profits paid to shareholders. This is common in well-established companies that generate consistent profits but may not need to reinvest all their earnings back into the business. Dividends provide shareholders with a return on their investment without selling their shares.
How Companies Use the Money Raised from Stocks
Now that we understand how companies raise money through IPOs and secondary offerings, what do they do with this money? Here are the most common uses:
Expanding the Business
Many companies go public to raise funds for expansion. This might include opening new locations, entering new markets, or investing in new technologies. Expansion is essential for growth, and raising money through stocks is one of the best ways to fuel that growth.
Paying Off Debt
Some companies use the money raised from selling shares to pay off existing debts. High levels of debt can be risky for a business, so reducing debt improves the company’s financial health and makes it more attractive to investors.
Research and Development (R&D)
For companies in sectors like technology, pharmaceuticals, or manufacturing, research and development are critical to staying competitive. The funds from stock sales can be invested in R&D to develop new products, improve existing ones, or explore new business opportunities.
Acquisitions and Mergers
Companies also use the money they raise from stock sales to acquire other businesses. Mergers and acquisitions are common ways for corporations to grow quickly, add new product lines, or enter new markets.
See Also: How To Use Stocks To Buy Real Estate
The Role of Underwriters
When a company decides to issue stock, it rarely handles the process alone. Investment banks and underwriters play a crucial role in ensuring a successful stock issuance.
What Are Underwriters?
Underwriters are financial institutions, typically investment banks, that help a company issue its stock. They assess the value of the company, help set the initial stock price, and market the shares to potential investors.
How Underwriters Make Money
Underwriters earn money by charging a fee for their services. This fee is usually a percentage of the money raised during the IPO or secondary offering. In addition, underwriters may purchase some of the shares themselves, with the hope of selling them at a higher price later.
Risks for the Corporation
Raising money through stocks can be highly beneficial, but it also comes with risks. Here are a few things companies must consider:
Loss of Control
When a company issues stock, it’s giving away ownership. This means the original founders and managers lose some control over the company. Large shareholders can influence decisions, sometimes even opposing the company’s management.
Stock Price Fluctuations
Once a company goes public, its stock price is influenced by the stock market. If the stock price falls, it can hurt the company’s reputation and make it harder to raise money in the future. Management is often under pressure to keep shareholders happy, which can affect decision-making.
Dilution
Issuing new shares dilutes the ownership percentage of existing shareholders. If a company issues too many shares, it can lower the value of each share, potentially leading to dissatisfied investors.
Conclusion
Corporations raise money from stocks primarily through Initial Public Offerings and secondary offerings. These processes allow companies to access large amounts of capital that can be used to grow the business, pay off debts, invest in research, or acquire other companies. Although there are risks involved, issuing stock is one of the most effective ways for companies to raise money and fuel long-term growth.
Understanding how companies raise money through stocks can give investors a clearer picture of how the stock market works and why it’s such an important tool for businesses seeking to expand and thrive.
