What is Dilution?
Dilution, also known as stock dilution or share dilution, is when the ownership percentage of existing shareholders decreases due to new share offerings.
When a company goes public, it releases an initial number of shares for sale. Any extra shares offered beyond that point (secondary offerings) dilute the existing shares in circulation.
Stock dilution is also known as equity dilution because it not only reduces a stockholder’s percentage of ownership in the company, but it often also reduces the value of the stock. Earnings per share (EPS), calculated by dividing net income by the float, determines a stock’s value.
How does stock dilution work?
When a company goes public with an initial public offering (IPO), it offers a specific number of shares for sale. For example, say a company has an initial public offering of 1,000 shares. Those 1,000 shares are the float. If 500 people each purchase 2 shares, each person owns 0.2% of the company. Later, the company decides to raise money by issuing another 1,000 shares, and another 500 people each buy 2 of those. Now there are 2,000 shares in circulation, and even though no one sold any part of their ownership in the company, shareholders who own 2 shares now own 0.1% instead of the previous 0.2%.
How stock dilution reduces investor influence
Since stock dilution reduces ownership percentages, it also dilutes investor influence by default. Each share of a company represents voting power at annual meetings, so when more shares are issued, it reduces the existing voting power in kind. This reduced voting power can force out other shareholders or force them to accept changes they may not have before the shares were diluted.
Most shareholders view stock dilution negatively because it reduces both the value of the asset they hold as well as the power and influence they hold. A company that issues a small percentage of new shares may not raise as much ire with shareholders as one who issues large amounts of new shares all at once.
Is stock dilution the same as a stock split?
Stock dilution is not the same as a stock split. In fact, they’re opposite terms. A stock split multiplies the number of shares each owner has by the factor of the split. For example, when someone owns 2 shares of a company and that stock splits 2:1, the shareholder then owns 4 shares after the split.
When stocks split, the value of the stock splits as well, thus the total value of 4 shares will initially equal the previous total value of 2 shares. Since these new shares are issued to existing stockholders, it does not dilute the shareholders’ value.
Why do companies dilute their stock?
Companies often dilute their stock as a way to raise funds for growth, research and development, to acquire new assets or companies, or to pay down existing debt. Usually the company feels that the future growth and profits are an acceptable tradeoff to the short term consequences of diluting the stock.
Put simply, stock dilution is like buying pizza for 4 people, then suddenly having to split it 6 ways instead. You paid the same but have less pizza. Along the same lines, however, it can be similar to dividing a plant. By breaking some plants into multiple pots in a garden, you provide room and resources for each plant to grow faster and larger.
Stock dilution can sometimes have this effect as well. Initially you have smaller pieces of the pie (or plant), and in some cases, investors simply live with less or exit their position. In other cases, investors adopt a wait and see approach, only to find the stock benefited greatly in the end because the dilution allowed the company to invest and grow.