What Is Dilution?
When a firm issues new shares, the percentage of ownership held by existing stockholders in the company decreases, a situation known as dilution occurs. When owners of other optionable securities, such as firm employees, or owners of stock option holders exercise their options, additional shares may be diluted. Each existing stockholder’s ownership of the company decreases as the number of outstanding shares rises, devaluing each share as a result.
A share of stock is an ownership stake in the corporation. The quantity of shares that will be initially issued when a company decides to go public, typically through an initial public offering (IPO), is approved by the board of directors. The “float”—the total amount of outstanding stock—is a frequent term. If a firm later issues more stock (often known as secondary offerings), they have diluted their stock since the float has expanded and the shareholders who purchased the original IPO now control less of the company than they did before the new shares were issued.
Simply breaking the equity “cake” into additional pieces results in dilution. The pieces will be smaller but there will be more of them. You will still receive your share of the cake, but it will be smaller than you anticipated and that is frequently undesirable.
Dilution lowers the company’s earnings per share (EPS, or net income divided by the float), which frequently drives down stock prices in the market, even though it primarily impacts equity ownership holdings. Due to this, many publicly traded firms release projections of both non-diluted and diluted EPS, which effectively provides investors with a “what-if-scenario” in the event that additional shares are issued. Based on the supposition that potentially dilutive instruments have already been converted into outstanding shares, diluted EPS is calculated.
As newly generated shares are issued to new investors whenever a company raises extra equity capital, share dilution may result. The benefit of using this method of capital raising is that the money the firm raises from the sale of extra shares may enhance its profitability and growth prospects, and consequently, raise the value of its stock.
Understandably, existing shareholders do not always view share dilution favorably, and businesses occasionally start share repurchase programs to help mitigate the effects of dilution. It should be noted that stock splits do not cause dilution. When a corporation splits its stock, existing shareholders receive extra shares while the share price is adjusted appropriately, maintaining their ownership stake in the company at the same level.
General Dilution Example
Let’s say a business has distributed 100 shares to 100 different shareholders. Each shareholder owns 1% of the business. Each shareholder would only hold 0.5 percent of the company if the secondary offering resulted in the issuance of 100 new shares to 100 additional shareholders. Each investor’s capacity to vote is also diminished by the lower ownership proportion.
Dilution Real-World Example
A public corporation frequently announces its plan to issue more shares, so reducing the value of its existing equity pool, long before it really does. This enables both new and experienced investors to make appropriate plans. For instance, on July 8, 2016, MGT Capital submitted a proxy statement that described a stock option plan for John McAfee, the newly hired CEO. The announcement also disclosed how previous firm acquisitions, paid for with a combination of cash and shares, were structured.
The executive stock option program and the acquisitions are both anticipated to reduce the number of shares currently outstanding. Furthermore, a proposal to issue freshly authorized shares was included in the proxy statement, indicating that the business anticipates further dilution in the near future.
Because dilution reduces the value of their existing equity, shareholders often oppose it. Contractual clauses known as “dilution protection” forbid or severely restrict the reduction of an investor’s ownership position in a company throughout subsequent funding rounds. If the company’s activities reduce the investor’s percentage claim on the company’s assets, the dilution protection mechanism becomes active.
For instance, if an investor has a 20% investment and the firm plans to raise additional capital, it must give the investor reduced shares to at least partially offset the dilution of the total ownership percentage. In venture capital investment agreements, dilution protection clauses are frequently present. Anti-dilution protection is another name for dilution protection.
An anti-dilution provision, usually referred to as a “anti-dilution clause,” is a clause in an option or convertible security. It guards against equity dilution brought on by later stock issuance that are sold for less than what the investor originally paid. Convertible preferred stock, a popular type of venture capital investment, frequently includes these.