Share Dilution - Working, Causes and Its Impact (2024)

Share dilution, also known as stock dilution occurs when a company introduces additional stocks resulting in the reduction of the value of shares of the existing investors. This is why investors are wary of it. If you are planning to buy shares of a company or multiple companies, you must familiarise yourself with the concept of share dilution.

Read on to get a complete understanding of stock dilution, its effects, what causes it and how to protect the shares against dilution.

When a corporation issues additional shares, lowering an existing shareholder’s ownership stake in the business, the process is referred to as share dilution, stock dilution or equity dilution.As the number of outstanding shares increases, the value of each current share decreases, resulting in a reduced or diluted ownership for each shareholder.

A company’s shareholders are its owners. Therefore, reducing an investor’s degree of ownership also diminishes the value of the investor’s assets, even if diluting shares is a fairly frequent practice for struggling companies.

A predetermined number of shares may be originally offered when a company goes public, typically through an initial public offering (IPO). “Float” refers to the shares that are still outstanding. The stock is considered to have been diluted if the firm offers new shares, which is referred to as a secondary stock offering.

The shareholders who bought the IPO will now have a lower stake in the ownership of the company because a share of a company’s stock indicates an ownership stake in the company.

A company may choose to dilute their shares for a variety of reasons:

1. To Raise Capital

Companies might need to raise more money to pursue new projects, align working capital, pay off their debts, and so on. In these cases, they might issue new shares and raise the required capital. They might issue new shares and raise the required capital in these cases. Doing so will increase the number of outstanding shares available in the market and the number of stakeholders, bringing the ownership for each existing shareholder down.

2. During Acquisition

Consider a situation where Company A has acquired Company B. The shareholders of Company B may be issued some shares of Company A as a part of the acquisition process. In this scenario, the stake of the original shareholders of Company A will reduce.

3. Offering ESOPs

Employee Stock Option Plans (ESOPs) offered to the employees of the company increase outstanding shares and cause dilution.

4. Convertible Options

Companies offer convertible options to lenders and independent contractors. When these parties opt for conversion to shares, it dilutes the ownership of existing shareholders.

Stock dilution directly affects investors’ ownership stakes. For instance, consider ABC Company with 10,000 outstanding shares. One of the investors in the company, Mr. K, holds 1000 shares, which means that Mr. K owns 10% of the company.

If the company is interested in pursuing a new project and raises capital by going public and offering 10,000 shares, the company now has 20,000 outstanding shares. This means that Mr. K’s ownership in the company has fallen from 10% to 5%. While this may not change the monetary value of Mr. K’s ownership, his voting rights will be reduced since there will be more owners in the company.

Similarly, the company’s earnings per share (EPS) may also change. It could result in a drastic fall in the EPS. If the company’s earnings increase significantly due to the dilution, then the EPS may barely be affected or even increase.

Simply put, stock dilution may not always have detrimental outcomes. Often, it may lead to fantastic results in the long term when it comes to mergers and acquisitions, or strategic takeovers. While it may temporarily dilute the stocks and ownership, it can significantly increase earnings in the long term.

The earnings per share of a company are calculated by dividing its net profit by its total outstanding shares. On a similar note, diluted earnings per share are calculated using the following formula:

Diluted Earnings per Share = (Net Income – Preferred Dividends) / (WASO + CDS)

Where,

WASO = Weighted Average Shares Outstanding

CDS = Conversion of Dilutive Securities

The basic EPS, diluted EPS, weighted average shares outstanding, and diluted weighted average shares are common dilution metrics reported by firmsto examine the dilution’s effects on their financial accounts.

The most typical form of protection against share dilution is the right of preemption. As long as they reinvest in the business on the same terms and conditions as the new investors, current shareholders will be able to keep their percentage shareholding and will have the first option to purchase any new shares that the company issues.

According to Section 561 of the Companies Act of 2006, a company’s founding shareholders are granted pre-emption rights. However, in accordance with the rules of the Companies Act of 2006, this measure may be disapproved by a special resolution of the shareholders if 75% or more vote in favour of doing so.

To prevent share dilution, anti-dilution shares and non-dilution shares can be utilised. Although both of these actions seem appealing to investors, they may have a detrimental effect on their investment and the long-term growth of the business by making it more difficult to attract new investors.

It’s also crucial to keep in mind that holding anti-dilution or non-dilution shares instantly disqualifies a shareholder from any SEIS (Seed Enterprise Investment Scheme) or EIS (Enterprise Investment Scheme) tax relief for which they may otherwise be qualified.

Pros

1. Fund Opportunities for Expansion

A business may issue more shares to finance initiatives or a purchase that will boost revenue.

2. Possibility of Higher Dividends

Despite the fact that more shareholders are getting dividend payments, payouts could rise as a result of rising revenue, leading to better profitability per share.

Long-term growth that could result in an increase in share price may be generated by a company using the funds raised from the issuance of additional shares.

Cons

1. Reduced Ownership Stake

The percentages of ownership held by existing shareholders will decrease when more shares are issued.

2. Potential for Lesser Dividends

If earnings per share do not increase to make up the gap, dividend payments may decrease because there are more stockholders to distribute dividends to.

With additional shares, the corporation will need to boost sales or EPS would drop.

Voting rights will decrease for current shareholders whose ownership percentages will drop.

Final Word

Even though share dilution is a commonly used means of raising capital for a business, it has its disadvantages. It is an interest-free source of sourcing capital for the business. The burden of repayment upon closing a business is the least as shareholders are to be paid in the end, after all the existing debtors have been paid off. For these reasons, owners might want to choose this mode of obtaining finance. However, they must consider factors like valuation and how much stake they lose while opting for it.

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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.