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Add-ons is a financial term it pays to understand. Bankrate explains it.

What are add-ons?

Add-ons are the issuance of new stock by a company that has already made its public offering and has outstanding stock. Add-ons may be used to raise cash, fund new or existing projects and pay for expanded operations. Add-ons raise money and increase a company’s value, but they can cause current shares to be diluted. Add-ons are also referred to as secondary offerings.

Deeper definition

When additional stock shares are issued by a company, current investors own a smaller portion of the company than they did prior to the add-on. For example, if a company issued 100,000 shares in its initial public offering and Bob bought 10,000 shares, he owned 10 percent of the company’s stocks. If the company then issues 20,000 additional shares and Bob doesn’t buy any additional stocks, he now owns 8.3 percent of the company’s stock. This is referred to as dilution.

One of the ways companies are measured is by their earnings per share. When the number of a company’s shares increases without the company’s income increasing, the earnings per share decrease. Decreased earnings per share usually cause the stock price to drop. However, add-ons don’t always result in the dilution of stock, particularly if the company is extremely popular.

Example of add-ons

While add-ons are often considered bad for current investors, this isn’t always the case. For example, if a company was worth $10 billion, then introduced more shares into the market, raised $2 billion and used that capital to buy out a competitor, its market cap may significantly increase. While the owners would then own smaller percentages of the pie than they did before the add-on, the pie would have grown substantially. The owners would now own smaller pieces of a larger pie.

Situations where companies use capital from add-ons to pay down debt or refinance debt at lower interest rates may improve the companies’ bottom lines and financial health. Additionally, rating agencies may upgrade the companies because they carry less debt. This may result in increased shareholder value in the long term, and be viewed as a positive financial move.

Companies sometimes make secondary equity offerings to allow existing investors to sell large numbers of shares. For example, secondary equity offerings may occur when a major investor, such as the founder of a private equity firm, sells a larger number of shares that would be difficult to sell in the normal course of trading. Since these shares were already outstanding, they don’t dilute the earnings per share and therefore don’t negatively impact the share.

Stock warrants and options protect individual investors against dilution. Both instruments allow investors to buy shares at predetermined prices. Stock options give the holder the right to purchase outstanding stock at a predetermined price. Stock warrants, on the other hand, are issued directly by the company and are produced by the company creating new shares.

Impact day refers to the day that the company makes its secondary shares available to the public. After the shares are made public, the stock’s price may quickly decline.

While add-ons can cause current investors to panic, they’re not always a sign of doom and gloom. Companies that use their capital to pay down debt, improve their financial bottom line, or make sound business investments may be making wise decisions that reap long-term gains for current shareholders. Short-term dilution may result in long-term gains for investors who are willing to hold on for the ride.

Use our calculator to determine whether you’re on track to reach your investment goal.

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