Equity Dilution

Article byWallstreetmojo Team
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

Equity Dilution Meaning

Equity Dilution is a method companies use to raise capital for their business and projects by offering ownership in exchange. This process, therefore, reduces or dilutes the ownership of existing owners. New equity is held by more individuals which dilute the ownership of the company. However, the expertise of new investors could improve the overall performance of the company.

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Equity dilution can have a significant effect on the company’s portfolio, especially when an individual or a company whose expertise would solve issues in the company such as supply chain management, manufacturing, or marketing. Their advice or opinions help start-ups raise the bar of their performance in the areas they lack experience.

Equity Dilution Explained

Equity dilution is when the ownership of the existing owners decreases due to new investors or issuing of new shares. These events occur after a fundraise or employee option pool is launched.

Dilution is usually carried out when a huge capital requirement for the company arises for growth plans or infrastructural development. For companies, it is important to understand that dilution beyond a point could lead to a decrease in their control over the decisions of the company.

However, capital-intensive businesses such as energy, iron, steel, and automobile industries require capital from time to time for their manufacturing process for which equity dilution might be one of the simpler and cost-efficient sources to raise funds.

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Formula

Let us understand the formula which can be applied to the equity dilution formula.

Equity Dilution

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Equity Dilution = (Existing Share – New Share) / Existing Share ×100

Examples

Let us understand the concept in depth through applying the equity dilutor calculator to a couple of examples.

You can download this Dilution Formula Excel Template here – Dilution Formula Excel Template

Example #1

There is a partnership firm of lawyers. In that firm, there are four partners, named A, B, C, and D. Partners have equal profit-sharing ratios, i.e., 25% each. Now, the firm wants to introduce a new partner name E. After the admission of E into the firm, the partnership deed was changed, and now, the new profit-sharing ratio is 20% each. Calculate equity dilution.

Solution 

Below is the given information –

Dilution Formula Example 1

Calculation of change in the ratio can be done as follows,

Example 1.1
  • =(25% – 20%) / 25%*100%

Change in Ratio will be –

Dilution Formula Example 1.2
  • Change in Ratio = 20%

Similarly, we can calculate the change in ratio for old partners –

Example 1.3

Explanation

A, B, C & D share an equal ratio in partnership, i.e., 25% each partner. Now the partnership firm has brought a new partner into the firm. Because of his admission to a firm, the existing partners must sacrifice 20% of their existing ratios. Now each partner shares 20% of the profit & loss of the firm.

Example #2

RHS Inc. is a private company, and all the shares have been held by its promoters only. Promoters of the company decided to list RHS Inc. in the stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more. Promoters want to issue an initial public offer to the public. Promoters are holding 70000 million common stocks at $1 each. Promoters want to issue 33600 million common stocks in the initial public offer, and they will hold remaining stock. Calculate dilution of ownership.

Solution

Below is the given information –

Example 2

Calculation of after dilution holding of promoters –

Dilution Formula Example 2.1
  • =7000 – 33600
  • =36400

Calculation of Dilution of Ownership can be done as follows –

Example 2.2
  • =(70000 – 33600) / 7000*100%

Dilution of Ownership will be –

Dilution Formula Example 2.3
  • =52%

Calculation of New Holdings

Dilution Formula Example 2.4
  • =100% – 52%
  • =8%

Explanation

Promoters of RHS Inc. want to make an initial public offer. They are offering 33600 million stocks in an initial public offerInitial Public OfferAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more out of 70000 million. Due to this offer, their ownership will be diluted. Before the offer, they are 100% owners of the company, but after the offer, they will be the 52%-part owner of a company, and 48% of the stock will be held by the public and a few financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more. Through the initial public offer, they have diluted their ownership.

Example #3

HNR Inc. is a public corporation. The company is listed on the US stock exchange (NYSE). The company has common equity of 90000 million stocks. The company has 40000 million convertible preference shares. Also, the company wants to issue follow on public offer (FPO)Follow On Public Offer (FPO)Follow on Public Offering (FPO), also known as a seasoned equity offering, is the method to raise capital by offering additional equity or preference shares after raising funds through Initial Public Offer.read more to raise funds from the public. The company is issuing 30000 million stocks following the public offer. The company had issued 20,000 million convertible debentures to the public five years ago. These debentures will need to be converted into common stock in the current year. One shareholder of the company is currently holding 8100 million stocks. Calculate equity dilution.

Solution

Below is the given information –

Dilution Formula Example 3

Current Holding

Dilution Formula Example 3.1
  • =8100/90000
  • =9%

Calculation of Common Stock & Current holding after conversion of preference sharePreference ShareA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more

Example 3.2
  • =90000 + 40000
  • Common Stock = 130000
  • =8100/130000
  • Current Holding = 6.23%

Calculation of Common StockCommon StockCommon stocks are the number of shares of a company and are found in the balance sheet. It is calculated by subtracting retained earnings from total equity.read more & Current holding after conversion of debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more

Dilution Formula Example 3.3
  • =130000 + 20000
  • Common Stock = 150000
  • =8100/150000
  • Current Holding = 5.40%

Calculation of Common Stock & Current holding after follow on public offer –

Dilution Formula Example 3.4
  • =150000 + 30000
  • Common Stock = 180000
  • =8100/180000
  • Current Holding = 4.50%

Calculation of Dilution of Holding after Conversion of Preference Shares –

Example 3.5
  • =(9% – 6.23%) / 9%*100%

Dilution of Holding after Conversion of Preference Shares –

Example 3.6
  • =30.77%

Calculation of Dilution of Holding after Conversion of Debentures –

Dilution Formula Example 3.7
  • =(6.23% – 5.40) / 6.23%*100%
  • =13.33% 

Calculation of Equity Dilution after Follow on Public Offer –

Dilution Formula Example 3.8
  • =(5.40% – 4.50%) / 5.40%*100%
  • =16.7%

Recommended Articles

This has been a guide to Equity Dilution and its meaning. Here we explain its formula and calculations along with practical examples. You can learn more from the following articles –

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