What Is Dilution? – Understanding, Example, Protection, and More
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What Is Dilution?
Dilution occurs when a company issues new shares that decrease 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 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 diluted their stock.
The shareholders who bought the original IPO now have a smaller ownership stake than before issuing the new shares.
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 part of the cake only that it will be a smaller proportion of the total than you had been expecting, which often not desire.
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 of the issue of the new shares.
Diluted EPS assumes that potentially dilutive securities have already converted to outstanding claims.
Share dilution may happen when a company raises additional equity capital, as newly created shares issued to new investors.
The potential upside of raising money in this way is that the company’s funds from selling additional shares. It can improve its profitability and growth prospects, and by extension, the value of its stock.
Understandably, share dilution not often viewed favourably 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 shares’ price adjusts accordingly, keeping their percentage ownership in the company static.
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.
Often a public company disseminates its intention to issue new shares, thereby diluting its current pool of equity long before it does.
This allows investors, both new and old, to plan accordingly. For example, MGT Capital filed a proxy statement on July 8, 2016.
Outlined a stock option plan for the newly appointed CEO, John McAfee.
Additionally, the information disseminated the structure of recent company acquisitions, purchased with a combination of cash and stock.
Both the executive stock option plan and the acquisitions expect to dilute the current pool of outstanding shares. Further, the proxy statement had a proposal for newly authorised shares’ issuance, suggesting the company expects more dilution in the near term.
Protection of Dilution
Shareholders typically resist dilution as it devalues their existing equity. Dilution protection refers to contractual provisions limiting or outrighting an investor’s stake in a company from reducing later funding rounds.
The dilution protection feature kicks if the company’s actions will decrease the investor’s percentage claim on the company’s assets.
For example, suppose an investor’s stake is 20%, and the company will hold additional funding round.
In that case, the company must offer discounted shares to the investor to partially make up for the overall ownership stake’s dilution.
Its protection provisions generally find in venture capital funding agreements. It protection sometimes refers to as “anti-dilution protection.”
Similarly, an anti-dilution provision is a provision in an option or convertible security. And it also knows as an “anti-dilution clause.”
It protects an investor from equity dilution resulting from later stock issues at a lower price than the investor originally paid.
These are common with convertible preferred stock, which is a favoured form of venture capital investment.
Dilution is the reduction in shareholders’ equity positions due to the issuance or creation of new shares. It also reduces a company’s earnings per share (EPS), which can harm share prices.
It can occur when a firm raises additional equity capital, though existing shareholders usually disadvantage.