Dilution

In the world, many companies and businesses issue new shares of stock to raise additional capital for the company. As a result, the company's total number of outstanding shares increases through the issuance of new equity.

The consequences of the following action will impact existing shareholders by decreasing the company's proportional ownership, which is referred to as stock or equity dilution.

This takes place when owners of other optionable securities (such as firm employees) or owners of stock option holders exercise their options. 

One of the most common questions is: Why do companies issue additional shares or equity?

The main reason is to:

• Fund expansion (growth) prospects or pay off any outstanding debt the company is still liable for.
• Employees may be given stock options and other securities with option rights by their employer. The stock options are converted into business shares when they are exercised. As a result, the corporation has more outstanding shares.
• Sometimes, companies may offer convertible securities to lenders, and when it is converted, new equity is issued as a result of the conversion of the securities.
• Some major shareholders raise additional equity to dilute the minority shareholders. There are several reasons why this occurs. The main one is to gain greater control of the company and to receive greater voting power.
  When this occurs, the shares of major shareholders are diluted as well. However, to keep their previous ownership of the company, they are issued more shares which will prevent their ownership percentage from reducing, thus preventing this from occurring.
• The acquired firm's shareholders may receive additional shares from a company that buys another company.

Understanding the concept

When a company raises its capital equity by offering shares to the public for the first time, this is referred to as an initial public offering (IPO). The shares outstanding in the market are referred to as a float. If the company decides to issue additional shares to the public, this is referred to as a secondary stock offering.

The secondary stock offering will increase the float, where the shares outstanding in the market will increase. Consequently, the investors who first purchased the stock through the initial public offering will get diluted and have a smaller ownership stake in the company.

To understand the process further, let's take an example. Suppose a company issues 1000 shares at $5  each. Later, the company requires additional capital to fund a new project and issues 500 new shares at $3. 

What is the impact of the stock issue on the wealth and voting control of the firm's existing shareholders?

Initially, the first investors who invested in the IPO received 1000 shares worth 100% of the company. After the issue of an additional 500 shares to new investors, the voting control of existing shareholders got diluted from 100% to approximately 66.66% (1000 / 1000 + 500).

On the other hand, the new investor's voting control is worth 33.33% (500 / 1000 + 500) of the company after the secondary offering.

Illustration

In the above example, we can see that the titular concept affects the equity ownership of investors. However, it also affects the earnings per share (EPS), decreasing companies' stock prices. Due to this reason, non-diluted EPS and diluted EPS are often published together by many public companies.

The diluted EPS essentially calculates a company's earnings per share, assuming the conversion of all convertible securities by the company.

The main difference between diluted EPS and non-diluted EPS is that non-diluted EPS considers a company's common share. In contrast, the latter considers all convertible bonds or convertible preferred stock, which could be changed into equity or common stock.

As the above example shows the impact of voting control on the firm's existing shareholders, now let us see how it impacts their wealth.

Initially, the value of existing shareholders is worth $5000 (1000 x $5), with one share valued at $5. After the issuance of new capital worth $1500 (500 x $3), the total wealth of stocks increases to $6500 (an increase of $1500 from the original $5000).

After the new capital was raised, the value of the existing shareholder's wealth decreased to $4333 (66.66% x 6500), and the new investor's wealth increased to $2166.5. Consequently, the stock price, which was previously $5, fell to $4.333 ($6500/1500). 

A Stock Split, Risks, and Protection Steps related to dilution

Dilution, in a nutshell, is the decrease in the value of shares of a company resulting from issuing new shares. And doing so may give rise to doubt, the risks arising from it, and some ways to protect an organization from the unfavorable effects of the titular concept.

One frequently asked question is: Is dilution the same as a stock split? 

The answer is a "big" no. There are some misconceptions about the two terms; however, both are two different aspects.

Share dilution and stock splits differ regarding how many shares the investor retains following each procedure. The titular concept reduces a shareholder's percentage ownership in the company to allow more shares to be issued as capital.

When a stock split occurs, the number of shares is divided, and current investors notice an increase in their equity based on the split ratio. For example, if the split ratio is 3:1, the number of shares will triple, and the stock price per share will be one-third.

1. Risks associated with stock dilution:

• The risk associated with the concept is that it damages stock prices, where the decline reduces the value of each share in stock prices.
• Additionally, because shareholders view the concept as a significant risk, it may be more difficult for the business to raise funds by issuing shares.
• It makes it more challenging to raise capital since potential investors will be less inclined to do so once they realize that the company has already diluted its shares.
• This practice can also make the stock more volatile, which may be risky.
• The stock price may fluctuate more wildly due to the lower stock price. For investors searching for steadiness, this may present a challenge.

2. Protection:

There are several ways for investors to protect themselves against the loss of equity ownership, and one way is through its protection. Dilution protection occurs when a company's actions threaten an investor's overall percentage claim on the company's assets.

The concept refers to protection provisions in agreements that are intended to restrict a company's capacity to reduce an investor's ownership stake in the business whenever future funding rounds or new stock offerings occur.

Usually, when the company presents subsequent funding rounds, some investors are offered shares to prevent the reduction in equity ownership. It is very common to see protection in venture capital agreements.

Advantages and Disadvantages

Although the process seems to keep many investors on the downside, many advantages must be considered. Some advantages and disadvantages are

Advantages:

• It may signal a sign of growth for the company. Companies tend to reflect the good performance of employees by rewarding company stock, which in a way, shows the company is doing well.
• It benefits external shareholders and reduces share dilution when a company issues new shares at a higher price point.
• By issuing more stock to its employees, the titular concept helps an organization increase internal ownership while reducing external ownership.
• The company's value rises even if the shares are sold on the open market. The additional fund brought in by raising the number of outstanding shares raises the value.

Disadvantages:

• Decreases the stock value
• Decreases the existing stockholders' ownership stake.
• It may signal a red flag since it may indicate a decline in the firm's financial health, which could prompt the sale of company stock and lead to a drop in the stock price.

Researched and authorized by Viriyan Dharma | LinkedIn

Reviewed by Sakshi Uradi | LinkedIn

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