If a company offers additional equities to market, perhaps to raise revenue or fund a new venture, buy a competitor, or launch a new product, the short term result is that the existing value and proportional ownership reduces.
It is not automatically a bad thing: if the company is successful in its aims, profits will rise. However, investors should be aware that it can lead to a decrease in value.
What Is Dilution?
Dilution occurs when a company issues new shares that result in a decrease in existing stockholders’ ownership percentage of that company. Stock dilution can also occur when holders of stock options, such as company employees, or holders of other optionable securities exercise their options. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.
A share of stock represents equity ownership in that company. When a firm’s board of directors decides to take their company public, usually through an initial public offering (IPO), they authorize the number of shares that will be initially offered. This amount of outstanding stock is commonly referred to as the “float.” If that company later issues additional stock (often called secondary offerings) they have increased the float and therefore diluted their stock: the shareholders who bought the original IPO now have a smaller ownership stake in the company than they did prior to the new shares being issued.
KEY TAKEAWAYS
- Dilution is the reduction in shareholders’ equity positions due to the issuance or creation of new shares.
- Dilution also reduces a company’s earnings per share (EPS), which can have a negative impact on share prices.
- Dilution can occur when a firm raises additional equity capital, though existing shareholders are usually disadvantaged.
Understanding Dilution
Dilution is simply a case of cutting the equity “cake” into more pieces. There will be more pieces but each will be smaller. So, you will still get your piece of the cake only that it will be a smaller proportion of the total than you had been expecting, which is often not desired.
While it primarily affects equity ownership positions, dilution also reduces the company’s earnings per share (EPS, or net income divided by the float), which often depresses stock prices in the market. For this reason, many public companies publish estimates of both non-diluted and diluted EPS, which is essentially a “what-if-scenario” for investors in the case new shares are issued. Diluted EPS assumes that potentially dilutive securities have already been converted to outstanding shares.
Share dilution may happen any time a company raises additional equity capital, as newly created shares are issued to new investors. The potential upside of raising capital in this way is that the funds the company receives from selling additional shares can improve the company’s profitability and growth prospects, and by extension the value of its stock.
Understandably, share dilution is not often viewed favorably by existing shareholders, and companies sometimes initiate share repurchase programs to help curb the effects of dilution. Note that stock splits do not create dilution. In situations where a company splits its stock, current investors receive additional shares while the price of the shares is adjusted accordingly, keeping their percentage ownership in the company static.
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General Example of Dilution
Suppose a company has issued 100 shares to 100 individual shareholders. Each shareholder owns 1% of the company. If the company then has a secondary offering and issues 100 new shares to 100 more shareholders, each shareholder only owns 0.5% of the company. The smaller ownership percentage also diminishes each investor’s voting power.
Real-World Example of Dilution
Often times a public company disseminates its intention to issue new shares, thereby diluting its current pool of equity long before it actually does. This allows investors, both new and old, to plan accordingly. For example, MGT Capital filed a proxy statement on July 8, 2016, that outlined a stock option plan for the newly appointed CEO, John McAfee. Additionally, the statement disseminated the structure of recent company acquisitions, purchased with a combination of cash and stock.
Both the executive stock option plan as well as the acquisitions are expected to dilute the current pool of outstanding shares. Further, the proxy statement had a proposal for the issuance of newly authorized shares, which suggests the company expects more dilution in the near-term.
Dilution Protection
Shareholders typically resist dilution as it devalues their existing equity. Dilution protection refers to contractual provisions that limit or outright prevent an investor’s stake in a company from being reduced in later funding rounds. The dilution protection feature kicks in if the actions of the company will decrease the investor’s percentage claim on assets of the company.
For example, if an investor’s stake is 20%, and the company is going to hold an additional funding round, the company must offer discounted shares to the investor to at least partially make up for the dilution of the overall ownership stake. Dilution protection provisions are generally found in venture capital funding agreements. Dilution protection is sometimes referred to as “anti-dilution protection.”
Similarly, an anti-dilution provision is a provision in an option or convertible security, and it is also known as an “anti-dilution clause.” It protects an investor from equity dilution resulting from later issues of stock at a lower price than the investor originally paid. These are common with convertible preferred stock, which is a favored form of venture capital investment.
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