Stock dilution is a phenomenon that occurs when more shares of stock are issued than previously existed. This reduces the percentage of ownership for existing shareholders. This can happen in various ways, but it’s most often tied to company growth, mergers, acquisitions, and other types of financing.
Stock dilution can be an essential factor for investors to consider when making investment decisions about a company. It can also significantly impact the value of an investor’s holdings in that company.
Part of success in business and investing is understanding financial concepts and gaining a solid foundation. A common question people ask is: what is dilution? We’ll answer that question in this article and explain why it matters.
Definition and Example of Dilution of Shares
Dilution is a decrease in the value of the ownership interest of a company’s existing shareholders. In other words, it refers to a reduction in the percentage ownership each shareholder has of the company.
It is caused by the issuance of equity by the company to raise capital. When a company wants to raise capital, it usually issues new shares or bonds. This dilutes the value of existing shares because it increases the total number of shares outstanding.
For example, suppose you own 10,000 shares in a company that has 1 million shares outstanding. You own 1% of the company (10,000/1,000,000). If the company issues another 100,000 shares, you will own only 0.9% of the company (10,000/1,100,000). The value of your original shares has been diluted by roughly 10%.
It’s best to think of stocks as pieces of ownership in a company. Each share represents a claim on that business’s assets and earnings. Stocks can be traded on the stock market, where they can be bought and sold by investors.
When you buy stocks, you’re purchasing a tiny bit of ownership in a company. A single share of a company like Apple or Amazon means you own a tiny slice of the company’s assets and earnings.
The main reason for dilution is to raise money to fund operations, but it can also occur when investors sell their shares or when employees exercise their options. Dilution is often described as “shareholder dilution” or “equity dilution,” but it can also apply to other forms of ownership, including debt or options.
What Causes Stock Dilution?
The leading cause of stock dilution is issuing new shares to raise capital. The company can either issue new shares or sell a portion of its existing holdings.
Another way stock dilution occurs is through stock repurchases when a company buys back its shares from investors.
Dilution is not synonymous with market loss, though its effect looks similar. When the market causes a stock to drop in price, it’s usually due to decreased revenues, poor sales, or other factors that affect the industry.
Stock dilution can occur in several ways, including:
Stock Options Converted to Common Shares
Stock options are a type of employee compensation that allows employees to purchase shares in the company at a set price. The price is called the exercise price and is typically set at or above the market price of the stock on the date the options are granted.
You agree to purchase shares at this price when you exercise your option. If you don’t exercise them, they will often expire worthlessly and become valueless.
Stock options convert to common shares when exercised by an employee or other holder of a vested stock option. When you exercise your stock option and buy 100 shares of XYZ Inc., you own 100 common shares and any rights that come with being a shareholder. These rights include voting rights, dividends, and interest from your investment return on capital.
When companies issue stock options to employees, those shares may later be converted into common stock if specific requirements are met. Stock options don’t give the holder equity in the company. That doesn’t happen until the option is exercised.
At that point, it’s converted to common shares, increasing the total number of shares the company has issued, causing dilution.
Creating or Offering New Shares
When a company needs to raise money, it can issue new shares, diluting existing shareholders’ ownership. If the company creates new shares, it’s called “issuing stock.” Issuing stock is a way for a company to raise capital without selling assets or borrowing money.
In other words, issuing stock allows investors to buy company shares instead of borrowing money from other investors.
The most common way to dilute is by issuing additional shares through an offering or secondary sale. This can happen when a company needs more funding or wants to pay down debt.
A company can issue new shares by selling them to investors in an initial public offering (IPO) or after going public. An IPO is when a company sells stock in itself for the first time. After an IPO, a company can also sell additional shares in the open market at any time.
When a company offers new shares, it may have to pay dividends to existing shareholders before paying out dividends to new investors who purchased those shares.
When a company issues stock, it must decide whether to give common stock or preferred stock. Each type of stock has its own set of terms and conditions that apply to it and affect how the company operates and its shareholders’ rights. Common and preferred stocks are both types of equity securities, but they’re not identical in every way.
Vesting of Employer Awarded Common Stock
Those shares are subject to vesting requirements when an employee is awarded equity compensation through an employer-sponsored plan, such as a 401(k) or ESPP.
Employee award plans often include vesting schedules that require employees to retain their shares for specific periods before selling them on secondary markets or receiving cash dividends from them.
For example, an employee may need to work for five years before being able to sell his or her vested shares on secondary markets or receive cash dividends from them.
That equity comes with a vesting schedule, locking in the employee’s service for a specific period. Once the vesting period expires, the stock is awarded to the employee. It essentially works the same as an option, thereby causing dilution.
Mergers and Acquisitions
There are many ways that stock dilution can occur. The most common cause is mergers and acquisitions. When a company experiences significant growth, it may need to raise capital to finance it. This may lead them to merge with or take over another company.
Merging two companies together or one company acquiring another involves combining the stock of each entity into one.
That’s done by the purchasing firm acquiring the company-owned common stock for the acquired company. That stock is often sold at a discount, which dilutes shares for common shareholders.
Mergers and acquisitions are often made to increase market share by entering new markets, acquiring technology or products, and gaining access to distribution channels.
What It Means for Investors
Stock dilution is a primary concern for investors. It means that the number of shares outstanding has increased, and therefore each share you own will be worth less. It reduces the percentage ownership that each investor has in the company. In other words, a 20% stake becomes 19%, or 2% becomes 1%.
When a company raises capital, it does so by issuing new shares to investors. This is known as equity financing. The more shares issued, the more diluted existing shareholders are. It increases the total number of shares available.
This means there are more shares to buy and sell, which helps stabilize prices over time (but doesn’t necessarily help individual investors).
This is bad news for existing shareholders because their ownership stake in the company decreases proportionately to the increase in the number of outstanding shares.
The company can boost revenue by utilizing that new cash to scale its sales process. Share prices will dip in the short run because of dilution, but the increased profitability will eventually raise them to a new level. That’s a win for common shareholders. In this scenario, dilution is a good thing and should be promoted before issuing the new common stock.
The good news is that this dilution isn’t necessarily permanent. If a company’s earnings grow quickly enough, its share price will eventually rise again, so your investment is worth what it was before the dilution occurred.
Is Share Dilution Good or Bad?
Share dilution is when a company issues shares or securities to raise capital. The company then sells these shares on an exchange, typically at a price lower than their face value. The difference between the market price and the face value is paid dividends to shareholders.
There are many reasons why companies issue more shares than they have in previous years. One reason is that they need more money for business expansion or to pay off debts from previous years’ operations.
For example, a company may need more capital from investors if it wants to buy out another smaller competitor. Another reason for issuing more shares is if the company wants to reward its executives or employees with bonuses or stock options for their work during the year (this can be done by issuing new stock options or selling treasury stock).
3 Tips for Startups to Manage Stock Dilution
You’re probably concerned about your company’s financial health if you’re a startup. A critical aspect of this is stock dilution, which refers to the reduction in the value of existing shares.
When you sell additional shares of ownership in your company, it can cause a drop in the value of existing shares. This is a common concern for new companies looking to raise money from investors or other sources.
Here are some tips for startups on how to manage stock dilution.
Research Different Financing Options
The cost of starting a business is often underestimated. It can be a significant challenge for startups to raise the necessary funds to cover operating costs, pay employees and invest in their businesses. Some other reasons why startups seek outside funding include:
- To obtain access to new markets
- To hire more employees or add new departments or divisions within the company
- To acquire another company
- To purchase equipment or tools
There are many ways to fund a startup, including:
Personal savings: This is perhaps the most common way for startups to get started. However, it’s also the most difficult option because most entrepreneurs don’t have enough money saved up, so they need to find other ways to get funding.
Family and friends: Friends and family may be willing to loan you money or invest in your company if they believe in your business idea and trust that you can make it profitable.
Venture capitalists are individuals or groups who invest in new companies in exchange for equity (or partial ownership). This investment is generally reserved for established businesses with proven track records and strong management teams.
Angel investors: Angel investors are private citizens who provide seed funding (small amounts of capital) through venture capital firms or angel networks — organizations made up of accredited investors who pool their money together on behalf of startups that need capital but don’t qualify for traditional financing options such as bank loans or venture capital investments.
Look into crowdfunding sites like Kickstarter and GoFundMe, which allow people to donate directly to projects they believe in (and get rewards for doing so). This is another way to raise money without giving up your company’s equity (i.e., ownership).
Model What Dilution Will Look Like for Different Options
Do the math. Some business owners look at the potential cash flow increase from an equity offering. Still, they fail to consider how this will affect the company’s equity multiplier and its impact on existing shareholders.
Those who buy stock in your company are among your most significant resources. Give them the consideration they deserve by mitigating their potential loss from dilution.
One of the tools you’ll need for this step is a fully diluted cap table. This will show you the total number of outstanding shares, including the totals for each option if they are exercised. Incorporate these numbers into your dilution model to fully understand the impact of issuing new common stock or offering stock options to new employees or partners.
Make Dilution Work for Your Company
Dilution is a common issue for many companies. Dilution is a business term that refers to a reduced share value due to new shares being added to the market. When a company issues new or existing claims repurchased by management, dilution can occur. The latter is sometimes referred to as “shareholder dilution.”
While dilution may sound bad, it’s not always bad news for shareholders. Companies issue new shares all the time — and often, it’s because they have a good reason for doing so.
The first step is ensuring that all your shares are correctly accounted for. This means ensuring that any shares held by founders and other employees are vested adequately so they cannot be sold without approval from management.
The second step is to make sure that the company has a good vesting schedule in place. This will prevent employees from selling their shares too early on in the life cycle of the company.
Finally, you should consider setting up an employee stock purchase plan (ESPP) so employees can buy shares at discounted rates with pre-tax dollars or through payroll deductions. This allows employees to become investors in their own company while also helping them get more involved in its success.