Capital increase: what it is, how it works and some examples

What is a capital increase? What does it mean to increase a company’s share capital and, above all, how does it work?

Capital increase is an extraordinary operation that companies can carry out to increase their share capital. By carrying out a capital increase, a company changes its share capital, resulting in a change in the company’s deed of incorporation.

But what does that mean? Under what circumstances do companies do this? In this article, we will explore in detail what a capital increase is, analyzing its meaning, how it works, why it is carried out and what the calculation formulas are through practical examples.

What is a capital increase

Capital increases are extraordinary operations that allow a company to increase its share capital. Share capital represents the total amount of payments and contributions made by shareholders of a company. It is indicated in the company’s incorporation deed. During a company’s lifetime, share capital can fluctuate both upwards and downwards. However, any change to the share capital must be approved by the extraordinary general meeting of the shareholders, as it represents a change to the articles of association and guarantees the protection of the company’s creditors.

Capital increases can take place in two ways, depending on whether or not this changes the company’s assets:

• the issue of new shares by the company;

• the increase in the nominal value of the securities already in circulation.

Types of capital increase: how does it work?

On the basis of the two methods listed above, capital increases can be divided into three different types, with consequent variations in the procedure’s functioning:

1) Free (or virtual) capital increase

It is carried out by assigning the new shares free of charge to the old shareholders or by increasing the nominal value of the existing shares. In this case we can speak of an increase in nominal capital. New securities must have the same characteristics as those already in circulation. This typology allows the company to increase its capital by transferring sums already present in the financial statements in the form of reserves, as provided for by article 2442 of the Civil Code, which states:

By converting available reserves and special funds reflected in the balance sheet into capital, the shareholders’ meeting can increase capital.

In this case, the newly issued shares must have the same characteristics as those in circulation, and must be assigned free of charge to shareholders in proportion to those already held.

The capital increase can also be implemented through an increase in the nominal value of the outstanding shares.

2) Paid capital increase

The subscription of new shares takes place through the payment of a consideration fixed on the basis of a placement price of the new shares which is between the nominal value and the market value. The company increases its capital thanks to new contributions. In this case, the increase is "real", because there is a real increase in the company’s equity thanks to new contributions. Assets may be contributed in cash, in kind or credits. The money giver will buy a certain number of newly issued shares. Members and third parties can participate in contributions. However, the former are offered the so-called "option right". In this way, the law offers the shareholder the possibility of not diluting, and therefore keeping unchanged, his shareholding. Once the placement of the new shares is completed, all shares, old and new, will have the same price. This procedure is the most widespread case and is regulated in Italy by article 2438 (and following) of the Civil Code, which states:

A capital increase cannot be carried out until the previously issued shares are fully paid up.

In case of violation of the previous paragraph, the directors are jointly responsible for the damages caused to shareholders and third parties.

In any case, the obligations undertaken with the subscription of the shares issued in violation of the previous paragraph remain unchanged.

3) Capital increase in mixed form

This type of capital increase consists of a paid offer of securities and a free assignment of new shares.

Capital increases are decreed by a bank or a company at specific moments in its corporate life.

The reasons for the capital increase

Companies can opt for a capital increase for several reasons. One of the most common situations is the need to deal with a liquidity crisis, i.e. the absence or scarce availability of money. During downturns, when demand falls and revenues drop, companies can experience cash crunches. In these cases, capital increases can be used to finance acquisitions, new investments or to cover losses.

There are two motivations that drive a company to carry out a paid capital increase (therefore carried out with the first method described above):

• find liquidity for investments;

• replenish the share capital due to a negative financial situation.

In the first case, the capital increase is frowned upon by the market, given that the financial resources raised will go to finance possibly productive investments and therefore future growth. Secondly, capital increases are implemented during moments of corporate crisis, which tends to lead to market negative appraisals.

Capital increase and option rights

The right of pre-emption can be defined as the right of current shareholders to be preferred to third parties in subscribing to the paid share capital increase. Once the capital increase has been approved, the company proceeds with the issue of new shares, offered as an option to shareholders in proportion to the shares held.

This option right maintains the proportion with which each shareholder participates in the capital unchanged and preserves the market value of the participation itself since the value of the stock on the stock market is destined to fall. This is also recognized for holders of convertible bonds and warrants.

Once the capital increase has been approved, the shareholder can subscribe to the new shares by exercising his option right, or sell this right on the market. This choice usually depends on considerations relating to the expected profitability of the investment.

Capital increase calculation: practical example

To better understand how a capital increase works, let’s proceed with a numerical example. The XYZ company has share capital divided into 2,000 shares, each of which has a nominal value of 150 euros, while on the market the share price is 175 euros. The share capital, therefore, amounts to 300,000 euros, while the market value is 350,000 euros.

Company XYZ wants to increase its share capital by doubling it, by granting one new share for each old share at a price (called the subscription price) of 160 euros.

The calculation to be carried out now is linked to the formula for the theoretical equilibrium price of the shares, which provides for the following:

PTAex = [(NAV x PAcum) + (NAN x CS)] / (NAV + NAN)

• PTAex = theoretical equilibrium price

• NAV = number of old shares

• PAcum = market price;

• NAN = number of new shares;

• CS = subscription price.

Reporting the data in our example, we will have:

PTAex = [(2,000 x 175) + (2,000 x 160)] / (2,000 + 2,000) = 167.50 euros

Following the capital increase shown in this practical example, we will have a share capital of 600,000 euros, 4,000 shares, a nominal unit value of 150 euros per share, a market price of 167.50 euros and a market value of the company XYZ of 670,000 euros.

Conclusions

Capital increases are extraordinary operations that allows companies to increase their share capital. This can take place through the issue of new shares or by increasing the nominal value of securities already in circulation. Companies can opt for a capital increase for various reasons, such as financing acquisitions, new investments or writing off losses.

The shareholders, in turn, can choose whether or not to participate in the capital increase and can take advantage of the option right to recover any losses. In any case, the capital increase requires a resolution at an extraordinary shareholders’ meeting and can strengthen the company’s financial structure.

Original article published on Money.it Italy 2023-06-26 12:42:00. Original title: Aumento di capitale: cos’è, come funziona, esempio di calcolo