So, now, how do companies raise money? You're in a company and you're trying to make a profit. You need money, say to build a new factory, or to launch a new ad campaign. So, you need the money now and you get profits later. How do you get the money? Well, there's two major resources, ways to do it. Well, I should, maybe three. One of them is retained earnings. I'll list that first. You can wait until you've made enough money, you save it up, and then you can build your new factory. That's one way. But it's slow because you have to wait until you've got the retained earning to do that. Often, young companies don't have much earnings because they're putting everything into the future. Another thing you can do is borrow money, either through banks. You can go to a bank and say I'd like a loan for my company. Or you can issue debt and sell that through a broker. You will issue a corporate bond, which brings in money. And you can issue shares, new shares. So suppose there are a million shares outstanding. You can issue another million shares. Now, the shareholders of the company, when you do that, are going to look at that and say wait a minute. What are we doing here? I used to own 10% of the company, and now I own only 5%, so I'm not so sure I'm happy about that. But then you on the board would say, but don't worry, we brought in millions of dollars for, and you own a share of that so the company has more now. So it's not bad for you, we need the money because we need to invest. And I think people understand that. So this is called dilution. When they issue more shares, your share in the company goes down, defined as the total of shares you have divided by total shares. And so, do you feel happy, or not? Well, you have to understand that it's diluted you. You no longer have the same vote that you used to have. You've given up some voting power in order to get money to expand the company. You might come to a shareholder or a shareholders' meeting and complain. But they'll say, but look this is the way it works. We can't expand without money. And this will make you, you'll' be treated equally to these other guys that came in and bought new shares. So you might as well back down. I guess that's the way, all these big companies did that. So that if you're an initial shareholder you once owned a big fraction of the company. It keeps going down but the company keeps going up in value. But here's why they call it equity, because all common shareholders are equal. Now, so what about issuing shares to get money? Well, some people said that issuing shares isn't very important anymore. That companies, when they need money, they borrow money or they use retained earnings. Karl Marx thought that. He said all this trade in stocks is trading mostly existing shares. It doesn't bring money into the company. All this transaction, it's just gambling, that's what Marx said. All these people playing a game. It's only when the company issues shares that share price matters economically. And Marx thought they don't do that very much. Stewart Myers, who's a professor of finance at MIT, wrote an article in 1984, arguing that well, I don't think he put it this way, Marx was right. I'm sure he didn't say Marx was right, but he was effectively saying that. because he looked at the data and he said, firms don't issue, when they first start, they issue a lot of shares. But after that, they're not issuing very much. So he said, proposed what he called the Pecking Order Theory of corporate finance. How do a corporation, this sounds like behavioral economist, now he might shudder if I identify him as a behavioral economist, but this is what this sounds like to me. The best way to raise money for corporate actions, according to what he said boards think, is retained earnings. You feel most comfortable. You go to a board meeting and say we need to build a new factory and, but, we've been making a lot of money, and we've got all this cash lying around. We'll use the retained earnings to build a new company. That feels really good going into the board. They'll say, well, why not? They'll go for that. But then if you say let's go to the bank and borrow money, then they get a little nervous because bankers sometimes ask for the money back and then you can be in trouble. So they're not quite so willing, so that's lower on the pecking order. But then the other thing you can say, all right, let's issue a new share. Now, they get really creepy. Now, they're thinking, are my votes going down? I don't like, it's so often shareholders are on the board. They're thinking, now, I"m going to be giving up power to other people, and if our profits don't go up, then we're going to be dividing them up among more people. So they don't like that. So Stewart Myers' article was very influential because it sounded right. This sounds like the way I can imagine myself behaving as a board member and he showed statistics emphasizing that. Now as of 1984, most firms had not done a single equity offering in the last 20 years. And when asked, are you thinking of issuing new shares, did not even contemplate doing it. From the years 1973 to 1982, 62% of capital expenditures came from retained earning. That is what companies were doing at that time. And only 6% from issuance of new shares. So if they never issue new shares, then what difference does the share price mean anyway to corporate activities? So this was a Marx was right conclusion. But they were criticized, notably Eugene Fama and Ken French. This is the Eugene Fama that we keep talking about, the efficient markets guy, but I think they were right here. Stewart Myers choice of 1973 to '82 was atypical. The stock market crashed in 1973, and it was still low, so you didn't get much money for the new shares you issued. Of course, nobody issued new shares, and, but even so, there was some forms of equity issuance even in that period. For example, they issued corporate shares to employees as compensation, or they had Warrants on the stock that were given to employees. So there was some issuance, even then, but the amount of equity issuance increased right after. They gave, 86% of firms issued some equity between 1993 and 2002. So it's really not true. Marx wasn't really right about the price of a share in the public market matters for the amount of money that a company can raise. So if the market price goes up, the company can get more money by issuing shares. And that encourages them to do that and make more investments. When the stock market goes down, the company starts looking at it. Typically, the board members are still optimistic about the company. And you say let's, we're down to $3 a share. You might be talking about doing a reverse split to try to bring it up. But you're thinking, are we selling these shares for only $3? I had my life's dreams. We're going to diluted down for just $3? I don't believe that and wouldn't do that.
