How companies issue and retire shares

Own 1% of a company today and you could own 0.8% next year, or 1.1%, without buying or selling a thing. Companies create and cancel shares all the time, and each change moves your slice.

Lesson L1.1.03 split markets in two. In the primary market, a company sells new shares and receives the cash. In the secondary market, investors trade existing shares with each other, and the company receives nothing. This lesson is about the primary market, and about its reverse: companies buying their own shares back.

Going public: the IPO. A young company is owned by its founders and a few investors. To raise more money, or to let early investors sell, it can hold an IPOInitial public offering: the first time a company sells its shares to the public and lists them on a stock exchange.. It hires investment banks as underwritersAn investment bank that manages a share sale, finds buyers and often guarantees to buy any shares left unsold. and publishes a prospectusThe legal document, approved by a regulator, that describes a company and the shares on offer.. The banks then market the shares to large investors on a “roadshow” and collect orders, a process called bookbuildingCollecting orders from investors at different prices before setting the final offer price.. The orders set the offer price. The shares are allocated, and trading starts on the exchange.

Take Lumen Robotics, a made-up company listing on Nasdaq. It has 80 million shares. At the IPO it sells 20 million new shares, and its venture investors sell 10 million of theirs, all at $15.00:

After the IPO there are 100 million shares, so Lumen is worth $1.5 billion at the offer price. Its free floatThe shares that are freely available to trade, rather than held by founders, governments or other insiders., the shares in public hands, is 30m ÷ 100m = 30%. If the shares close their first day at $18.00, a 20% “pop”, the buyers gain $90m that the sellers could have had. IPOs are usually priced a little below what the market will pay, to make sure every share is sold.

Dilution. Lumen's founders hold 40 million shares. Before the IPO that was 50% of the company; after it, 40%. Their slice shrank, which is dilutionA fall in an existing shareholder's percentage of a company when new shares are issued.. But the company now has $300m more cash, so a smaller slice of a bigger pie need not be worth less. Dilution hurts when new shares are sold too cheaply.

Step through Lumen's life to see the share count move:

Raising more later: rights issues. A listed company that needs more money can sell new shares again. In many markets existing shareholders have pre-emption rights (L1.5.01), so the new shares are offered to them first in a rights issueAn offer of new shares to existing shareholders, in proportion to what they hold, usually at a discount to the market price.: for example, one new share for every four held, at a discount to today's price. The discount makes the offer attractive, but it also pulls the share price down, to the theoretical ex-rights priceTheoretical ex-rights price: the expected share price once the new shares from a rights issue are in issue.. Each holder can take up the rights (pay for the new shares), sell the rights to someone else, or do nothing.

Giving money back: buybacks. A company with spare cash can pay a dividend, or it can buy its own shares in the market. In a buybackA company buying its own shares from investors, then cancelling them or holding them in treasury. the shares are cancelled or held “in treasury”, so fewer shares share the same profit. If Kiri Electric, earning ¥50bn, spends ¥50bn buying 10% of its shares, its earnings per shareEarnings per share: the company's profit for the year divided by the number of shares. rise from ¥50.00 to ¥55.56 (+11.1%). A dividend pays every shareholder; a buyback pays only those who choose to sell, and the rest end up owning a bigger slice.

Two short results. Neither needs new maths: they are averages and divisions you already know.

The ex-rights price. A company has $N$ shares at price $P$. It issues $n$ new shares at subscription price $S$. Start from what the price must be after the issue, then fill in each part:

It is a weighted average of the old price and the subscription price. A right to buy one new share is worth what you save by using it: $\text{TERP} - S$.

Earnings per share after a buyback. With earnings $E$, a buyback of amount $B$ at price $P$ cancels $B / P$ shares:

In the rights issue, push the discount up to 50% and compare your three choices. Then switch to the buyback and watch earnings per share and your slice grow as the company spends more.

Nordlicht AG, a German engineering firm, has 100 million shares trading at €10.00. It announces a 1-for-4 rights issue at €8.00. You hold 1,000 shares, worth €10,000.

Selling shares to the public needs a prospectus approved by a regulator: in the EU under the Prospectus Regulation, in the US through registration with the Securities and Exchange Commission. Banks face an extra rule on the way out. Because shares are a bank's loss-absorbing capital, an EU bank needs its supervisor's permission to buy back its own shares. In March 2020, at the start of the pandemic, the ECB and the Bank of England asked the banks they supervise to suspend dividends and buybacks, and the US Federal Reserve later restricted them too, to keep capital inside the banks.

• In an IPO, new (primary) shares raise money for the company; existing (secondary) shares sold raise money for the sellers.
• The free float is the part of the shares in public hands.
• Issuing new shares dilutes existing holders' percentage. It costs them value only if the shares are sold too cheaply.
• A rights issue offers new shares to existing holders at a discount. The price falls to the TERP = (NP + nS) ÷ (N + n). Take up or sell your rights; doing nothing loses value.
• A buyback cancels shares, raising earnings per share and the slice of everyone who keeps their shares.

IPO

Initial public offering: the first time a company sells its shares to the public and lists them on a stock exchange.

Underwriter

An investment bank that manages a share sale, finds buyers and often guarantees to buy any shares left unsold.

Prospectus

The legal document, approved by a regulator, that describes a company and the shares on offer.

Bookbuilding

Collecting orders from investors at different prices before setting the final offer price.

Free float

The shares that are freely available to trade, rather than held by founders, governments or other insiders.

Dilution

A fall in an existing shareholder's percentage of a company when new shares are issued.

Rights issue

An offer of new shares to existing shareholders, in proportion to what they hold, usually at a discount to the market price.

TERP

Theoretical ex-rights price: the expected share price once the new shares from a rights issue are in issue.

Buyback

A company buying its own shares from investors, then cancelling them or holding them in treasury.

EPS

Earnings per share: the company's profit for the year divided by the number of shares.

Share split

Dividing each share into several, for example two for one. The number of shares changes; their total value does not.