A secondary stock offering comes with a sharp drop in a company’s stock price. Rapid price declines make investors nervous, wondering if the company is facing troubles.

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The recent sale of 6.5 million new shares by one of my favorite high-yield dividend stocks highlights how this type of transaction can benefit investors.

Let me show you how you’re about to profit…

Hercules Capital (HTGC) is structured as a business development company (BDC). The legal restrictions on BDCs limit how much debt they can carry, so to grow, a BDC will need to issue shares to increase its equity capital.

BDCs provide equity and debt financing sources for small-to-medium-sized corporations. They act as commercial lenders to companies that cannot get financing through the regular banking system.

BDCs operate under special rules. They are structured as pass-through entities, which means they do not pay corporate income tax if at least 90% of net investment income is paid out as dividends. These companies are limited to debt that is no more than two times equity. (Until 2018, the limit was a debt of one times equity.) Most BDCs have continued to manage close to a one-to-one debt-to-equity ratio.

Because a BDC pays out most of its earnings as dividends and the amount of debt it can carry is capped, to grow, it is necessary to issue new shares to increase equity capital. The better-run BDCs will occasionally come to market with a supplemental share issue.

A BDC can price its market shares at a premium or discount to the NAV or book value. At first glance, it may seem that buying a BDC at a discount would be the better deal. In practice, that is not the case. The Hercules Capital supplemental issue shows us how that works.

On August 8, the company priced an offer of 6.5 million shares. Hercules Capital traded for around $17.00, which is our indication of the private placement price. Using these numbers, the company raised $110 million. However, the Hercules Capital book value as of the end of the second quarter is $10.96 per share. Based on the NAV, the value of the 6.5 million shares was $71.5 million. The company received $110 million when selling $71.5 million worth of shares.

That math shows why you want to invest in BDCs trading at a premium to their book values. Secondary stock issues are immediately per-share accretive. Also, Hercules Capital can now borrow at least another $110 million, allowing it to make $220 million of new portfolio investments.

BDCs that trade at a premium will be the ones that can grow the dividends they pay to investors. Over the last three years, the Hercules Capital regular quarterly dividend increased from $0.32 to $0.40 per share. The company has also declared a supplemental dividend every quarter during that period. Hercules Capital yields 8.9% on the regular dividend rate. Growth-focused BDCs are an excellent source of high-yield stocks.

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