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What Is Stock Dilution?
Stock dilution (also known as equity dilution) occurs when shareholders’ ownership percentage in a company decreases. When a company needs to raise money to grow, it needs to gather new investors. One way to do this is to introduce additional shares in order to attract more buyers—but when a company issues new shares to new investors, existing shareholders end up with a diminished ownership stake.
It is important to note that the issuance of new shares is not the same as a stock split. A stock split is when a company issues more shares to existing shareholders. This helps keep stock prices affordable, while not diluting the value of the stocks themselves.
Example of Dilution
If Business A’s total outstanding shares is two million, and you hold 250,000 of those shares, you own 12.5 percent of the company. If the current share price is $10, then the market value of the company is $20 million, making your investment worth $2.5 million. If Business A needs new capital and issues 500,000 additional shares, then your percentage ownership drops to 10 percent. You now own less of the company, which means a smaller piece of the pie.
Dilution continues if the infusion of additional shares does not end up profiting the company, which then lowers the value of your investment. However, stock dilution as a short-term means of raising funds can sometimes benefit a company’s earnings if the money from new investors makes the business more profitable. That increase in profitability boosts the value of your own personal ownership, making your smaller percentage worth more.
How Do Shares Become Diluted?
Many companies experience periods of share dilution. There are actually a number of ways this can occur:
- New equity: Adding additional stock can dilute shares. When a company needs to raise money—whether it’s to boost revenue, cover renovation costs, or invest in a new partnership—one of the ways it can do this is by issuance of new stock via secondary offerings. An initial public offering (IPO) refers to when a company first sells its shares on the stock market. Afterwards, if that company needs to increase equity, it introduces another wave of new shares—a secondary offering—that become available to the public. When this new stock is added, the total number of shares available increases, which then decreases the value of each individual share.
- Stock options: Sometimes an employee of a business is granted stock options, which allow them to buy the common stock of a company at a set price. Should they choose to exercise their stock options, they add their shares to the pool, resulting in an overall devaluation.
- Convertible securities: An employee may also be offered convertible securities—like preferred shares—which allow them to earn a fixed dividend that pays out before the common stock. Preferred shares do not contribute to company growth and will never earn more than their fixed rate, regardless of company success. Because of this, preferred shareholders often have the option to transfer their preferred stock into common stock at a preset ratio set by the company. This new wave of common shares further dilutes the market.
What Are the Effects of Dilution?
While a short period of dilution may help the profitability of a company, dilution in the long term can have lasting negative effects:
- Reduction in value: Individual investments become worth less over time as an overabundance of shares flood the market.
- Imbalance of voting power: Shareholders with dwindling ownership percentages see a reduction in voting power, leaving them vulnerable to be taken advantage of by investors with larger ownership stakes who have more control.
- Loss of confidence: If investors feel like the value of a company is falling, they may lose trust in the business. Losing the confidence from the people who have invested their money into your venture will not be beneficial in the long run.
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