The moment an organization issues additional stock to new shareholders, it can decrease the value of existing investors’ shares and their ownership of the company. This problem is termed dilution. Stock dilution is also sometimes referred to as equity dilution. Fundamentally, It is a risk that investors must be conscious of as shareholders. Also, they must take a more confidential look at how dilution occurs and how it can influence the value of the shares.
Stock dilution alludes to the loss of common share value due to an increase in the number of units of equity. As more stock becomes available to shareholders and potential shareholders, each ownership share holds a smaller piece of the organization via dilution. The leading cause of dilution is the total amount of available wealth becomes distributed over a more comprehensive number of shares.
What is stock dilution?
Stock dilution is a decline in the percentage of share ownership by investors owning a particular stock, primarily due to the company issuing new shares of stock, which “dilutes” the value of existing stock held by shareholders. The company’s total number of shares available is boosted by new stock issued, which triggers a dilution of shares owned by shareholders.
The organization often issued new stock shares through various mechanisms, such as stock options for employees, board members, business vendors, restricted shares, or performance shares. Pretty much every time they do so, the worth of the stock is compromised. Or then again, it might dilute share values after primary or secondary stock issues, similar to the first public offering, a favored stock issuance, or issuance of convertible bonds.
Stock dilution can significantly affect portfolio performance. For example, for a company with 100 shares outstanding, each share authorizes the owner to 1% of company earnings and 1% of the company’s voting power. Take the case that Ray held five shares of stock, he would own 5% of the company. Now consider the company holds ten new shares of stock to be used for stock options to officials. In case all of those shares are issued, the company will have 110 shares outstanding, and five shares of Ray will now lead a smaller portion of the earnings and voting power of the company. The formula to estimate the potential dilution of issuing these 10 shares is as described below:
- A = Incentive Shares Reserved in Plans, but unissued
- B = Incentive Shares Outstanding
- C = Total Common Shares Outstanding
- Potential Dilution (Overhang) = (A + B) / (A + B + C)
Applying this formula to the ray’s example above would produce 10 / (10 + 100) = 9.01%. This means that the existing earnings of a shareholder and voting power would be diluted by 9.01% if the company issued all 10 shares.
Stock dilution also affects more than just the shares value held by the stockholder. It also confines the stock’s worth in alternate ways, including the stock’s income per share, shareholder’s voting rights, and the stock’s market value. It also restricts the value of the stock in other ways, including the stock’s earnings per share, shareholder’s voting rights, and the stock’s market value.
What are some major causes of stock dilution?
There are numerous situations in which shares are diluted. These consist of:
- Conversion by holders of optionable securities: Stock options allowed to people, like employees or board members, may be converted into common shares, boosting the total share count.
- Secondary offerings to support additional capital: A firm looking for new income to fund growth opportunities or service existing debt may issue more shares to uplift funds.
- Allowing extra shares in exchange for acquisitions or services: A business may contribute new shares to its purchasing shareholders. Smaller companies sometimes also contribute new shares to people for services they give.
- Some organizations may issue additional shares to look for added capital for growth opportunities or settle outstanding debts. One can improve the value of the company’s stock and its profitability through the money gained from issuing new shares in the market.
- A business buying another company may issue supplementary shares to the shareholders of the acquired company.
- A business may give stock options to its employees and other optionable securities. When the stock options are exercised, they are converted into the company’s shares. Thus, the number of outstanding company shares increases.
- Smaller businesses might issue shares to independent service providers.
- Some businesses may issue warrants or other convertible securities, such as bonds. Lenders usually get warrants issued. When they are converted, new shares are added to the pool of outstanding shares of the companies.
- Shareholders with a significant stake in the company can use share dilution to remove other shareholders with less ownership in the company or get the latter’s consent to the plans they usually would not agree to.
How does stock dilution affect stock price?
Dilution impacts the portfolio value as per the number of additional shares issued and the number of shares held. Dilution affects the share price and the earnings per share (EPS) of the company.
For example, an organization’s EPS may be 50 cents per share before issuing additional shares, reducing to 38 cents after dilution. Nevertheless, the EPS may not be changed if the dilution produces a significant increase in earnings. The funds from dilution may assist in boosting the revenue, which can offset the increased number of shares, and the EPS might not change.
Public companies also compute diluted EPS to define the potential impact of dilution on stock prices if stock options are exercised.
A decrease in the book value of the shares and the earnings per company share is experienced due to dilution.
Pros and Cons of Stock Dilution
Where are the benefits and downsides of stock dilution? Here’s a thumbnail sketch:
Advantages of stock dilution
- Stock dilution is a sign of growth as it rewards the value and performance of employees. It marks the company as a stable company willing to share its good fortune with its workers. With increased internal share ownership, the company and its workers are considered productive and highly valued.
- In case an organization releases new shares at a higher price point, this is a win for external shareholders as well as share dilution gets minimized.
- If a company wants to decrease external ownership, dilution assists in increasing internal ownership simply by issuing more stock to its employees.
- The company’s valuation increases even if the shares are issued in the open market. The value is increased with the additional inflow of funds that is made by increasing the outstanding shares.
- The moment an organization issues shares priced higher than the intrinsic value, an external shareholder will always benefit without the ownership stake being diluted.
Disadvantages of stock dilution
- Generally, the investing public doesn’t support the idea of issuing new stock to internal shareholders. That move decreases the stock value in multiple cases and also reduces the ownership stake of existing shareholders.
- Investors will often view a regular pattern of new stock issuances to raise money. This is a warning sign that the company is in dire financial health, potentially leading to a sale of company shares and experiencing a decline in stock price.
- In many cases, investors hate dilution as it represents a transfer of ownership from insiders to external shareholders.
- Reduces the ownership stake of existing shareholders.
How to prevent stock dilution?
The most common type of protection for share dilution is the right of pre-emption. This provision permits the existing shareholders to have the right to refuse any new shares issued by the company. This allows them to re-invest in the company on the same conditions and price as the new investors and can easily maintain their percentage shareholding.
The initial shareholders of a company are authorized pre-emption rights. Otherwise, there can be provisions in a company’s articles of association or shareholders agreement that would dictate the dis-application of pre-emption rights. Still, this measure can be disapplied by a special resolution of the shareholders.
One can use Anti-dilution shares and non-dilution shares to guard against share dilution. While both of these areas seem attractive to investors at face value, they can harm both the investor’s investment and the company’s long-term growth in terms of making it harder to raise further investment.
The rights attached to anti-dilution shares can guard an investor’s shareholding in a company against economic dilution in the future. Suppose a company issues new shares in another round of investment at a lower value than the initial shares. In that case, the company will top-up the initial investor’s shareholding as compensation.
The rights attached to non-dilution shares render them immune to dilution altogether as the company can issue no new shares. However, this limits any further investment that one could make in the company, which could restrict the company’s growth and negatively impact the value of the initial investor’s shareholding in the company.
Why Stock Dilution shouldn’t always be avoided?
The disadvantages of these methods will probably outweigh the potential benefits. This is especially when you correct the misconception of share dilution entirely. One of the significant drawbacks of these is the lack of fairness. A large part of share schemes dilutes all shareholders somewhat by default and for a good reason. Equity should be fair, and founders should commit to sharing ownership fairly, or they are missing at least part of the point. As such, it is essential to keep investors who share the same values. Another major reason why founders shouldn’t be so concerned about dilution is the positive impact of sharing equity can surpass the consequences of dilution entirely.
Manage Your Company Shares on Eqvista
Dilution can intensely influence the value of your portfolio—adjustments to a company’s earnings per share and ratios for its valuation when dilution happens. Investors must look out for indications of potential share dilution and learn how it could influence their shares’ value and overall investment.
Eqvista is an advanced cap table and equity management system that allows companies to track the stock dilution in their company. You can even model different funding rounds to see how much dilution would occur with new investments. We also offer 409a valuations to find the value of your company. Contact us today to know more or sign up for a free DEMO!