As the world starts to readjust for the long-term consequences of the COVID-19 pandemic, businesses must find ways to guarantee financial stability. For many, this means turning to investors for capital.
But why are companies doing this? Should investors take such a leap of faith with their money? And what are the long-term consequences of saying yes or no?
Reasons for seeking investment
Turning to investors for an injection of capital is nothing new, but the reasons why businesses take this step can vary greatly.
Most recently, Premier Inn owner Whitbread hoped to raise over £1 billion from investors in a bid to strengthen its balance sheet following restrictions on restaurants, hotels and bars during lockdown. Shareholders were offered the chance to buy one new share for every two existing ones they own.
Then again, other businesses use the money to grow their product offering or expand their presence into new markets. For example, online fashion retailer Boohoo raised nearly £200 million through a share placing in order to take advantage of suitable merger and acquisition opportunities.
What happens if you don’t invest?
Take the example of Whitbread, which is known as a rights issue, and you will find yourself with the same amount of shares as before but they will be worth less, as there are more of them in issue. This is called a dilution.
If a company originally had 100 shares and you owned two of them, you have two per cent of its stock. But if it issues another 100 to raise money and you don’t decide to invest, you will end up with just one per cent of its stock. For this reason, the vast majority of investors decide to buy the additional shares because they are often discounted too.
However, when a company announces a rights issue, its share price usually falls – Whitbread shares fell 11 per cent. This is because investors know there will be cheaper shares on the market due to the discounting, and that the company could be struggling financially.
What happens if you do invest?
Chances are you will say yes to the investment for fear of dilution alone. And even if the business is struggling, your shareholding could be worth a lot more in the future if things turn around.
Then again, the opportunity to buy more shares in a company should be evaluated on a case-by-case basis. After all, you are effectively being asked to take a punt on the company’s future fortunes.
As for the company itself, capital raising is usually cheaper than going to the bank and trying to borrow money. It’s also less risky than issuing bonds – if the company collapses, shareholders get nothing but bondholders have rights.
So, when it comes to investing in companies during the current crisis, there’s two potential attitudes and outlooks – a rights issue could ensure a stronger reemergence in the future, whereas a share placing allows for a shorter-term weathering of the situation.