Stock Dilution is defined as decrease in the percentage of the ownership held by the existing shareholders of the company because of the new shares issued by the company and such a dilution can happen either by offering shares in exchange of funds or can also be due to conversion of dilutive securities like stock options, convertible debt etc.
What is Stock Dilution?
Stock dilution is a corporate action that decreases the ownership of the existing stockholders of a company by means of issuing new stocks in the market. The new stock increases the total outstanding shares in the market which results in dilution of the ownership of the existing shareholders. An increase in the outstanding shares can be a result of a primary or secondary market offering which includes an Initial Public Offering, issuance/conversion of convertible bonds, warrants into stock, and issuance of preferred stock, new stock options, etc.
- Stock dilution may affect the ownership percentage, earning per share, voting rights and the market value of the stock. With the additional flow of shares in the market even though the ownership gets diluted, the valuation of the company increases due to the additional flow of funds by the sale of the new shares.
- In simple words, it is an additional issuance of stocks by the company that eventually results in a reduction of ownership stakes of existing shareholders. After dilution, the shareholder is either in a bad condition or maybe in a neutral condition and for some it actually turns out to be good.
Examples of Stock Dilution Types
In the examples below, the three primary sources of stock dilution have been explained
‘Mber Inc’ is a design and engineering startup and has a new coffee mug that customizes the drinking temperature of coffee or tea. Year ending 2018, Mber had a common stock outstanding of 100,000 shares with a market capital of $1 million and $100 of net profits. Merry Andrew is an individual investor who bought 10,000 shares of Mber on 31st Dec 2018. When the company announced its earnings, Merry was merrier to know that his investment has earned $10 of Mber’s profits.
#1 – Stock Dilution through Issuance of New Shares to Employees
In 2019, Mber issues 100,000 stock options to its CEO. As of now, it has an outstanding share of 100,000 shares but eventually when the CEO exercises the stock options. Mber will have a diluted share count of 200,000 shares.
Well, after this nothing is merry for Merry, our investor. He still owns 10,000 shares and once the company issues the additional stock his ownership stake will be diluted. The initial outstanding share count was 100,000 and the profit earned was $100, Merry was entitled to $10 of the profits which were 10% (10,000 / 100,000). After the issuance of the additional shares in the market, Merry’s ownership will not be 10% but would topple to 5% (10,000 / 200,000) of the total outstanding shares which means, for every $100 profit, Merry would only earn $5. Don’t you feel bad for Merry? The CEO just got lucky with this move; he gets his hands on 50% (100,000 / 200,000) shares of the company.
#2 – Issuance of New Shares for Expansion
Let’s assume Mber wants to expand its business but the temperature control mug is yet to be a hit among the masses. That is a problem! The management thinks the solution to this problem is to buy out its rival, Vecup. Since Mber hasn’t sold any of the mugs and has no money to make the move; it would exchange its own shares to Vecup shareholders. Confused?
Breaking it down – Mber will take ownership of Vecup in exchange for new shares issued in the market. Vecup being a huge player in the market has a market capital of $20 billion and Mber having a market value of $10 per share will need to make an issuance of 2 billion new shares to crack this deal. This will dilute the ownership of its existing shareholders, including Merry by 200,000 times. Looking at the larger picture, Merry’s cut from the profit after the merger of Mber and Vecup looks much smaller than his cut from the profit of Mber alone. But the net profit would be much bigger. Merry would receive a small share from a bigger profit of Mber and Vecup in exchange for his original investment of a big share from a small profit. Simply put, it is a smaller piece out of a bigger cake.
#3 – Secondary Offering
Stock Dilution can also be done by secondary issuance. Earlier, when Mber issues 100,000 shares to its CEO, the shareholders are impacted negatively since it is offered at a nominal price. Before the management issues the new shares to the CEO, Mber starts to make it a hit among the masses with the cutting edge technology and the state of the art service to its customers. Mber’s shares burgeon and sell the additional 100,000 shares at $500 per share. If the share price has increased without any change in its intrinsic value, Merry will be merrier than ever.
Mber’s worth increased not just because of the mass popularity, the intrinsic value of the company increased as it traded $50 million for the 100,000 additional shares that were issued in the market. Merry’s 5% stake i.e. 10,000 shares out of 200,000 of shares now have a whopping $2.5 million value.
Advantages of Stock Dilution
- For an organization which wants to reduce the external ownership, dilution helps in increasing the internal ownership by issuing additional stocks to its employees.
- Even if the shares are issued in the open market, the valuation of the company increases in the market with the additional inflow of funds made by the increase in the outstanding shares.
- When a company issues shares priced higher than the intrinsic value an external shareholder will always benefit without ownership stake being diluted.
- Investors hate dilution as in most cases it represents a transfer of ownership from external shareholders to insiders.
- Reduces the ownership stake of existing shareholders.
- Stock Dilution decreases the ownership stake of existing shareholders in a company.
- It is one of the most important factors for a startup.
- An investor can benefit, make losses or have no change in his position depending on the situation.
This has been a guide to what is Stock Dilution and its definition. Here we discuss the three primary source of stock dilution along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –