How does stock dilution work?

Companies have the liberty to dilute their existing number of shares by issuing more shares to potential shareholders. Issuing shares can be for reaching out to more investors, or the result of recent acquisitions, or even due to employee stock options. When a stock dilution happens, it’s usually announced to existing shareholders and new investors, and it equally impacts both the management of the company and the shareholders.

Stock dilution happens when the shareholders of a company experience reduced power to claim their ownership in the company shares.

Sometimes companies roll out opportunities for the public or new investors to hold more shares at a certain point in their operation. New shareholders, after determining the value of the company status, decide whether to take up the ownership of these shares or not. This may cause the existing shareholders to experience reduced ownership in the company functions. The diluted ownership experience is called stock dilution or share dilution. As the number of company shares goes up, the rate of ownership of the shareholders in the company goes down.

Imagine you are a shareholder in a company that has 10,000 shares offered. Now, the company plans to bring in 10,000 more shares for new shareholders. The old shareholders, including you, will experience a 50% reduced ownership in the company shares because the number of outstanding shares has increased by 50%. The new shares added to the pool are called dilutive shares, and the rate by which the shareholders experience a drop in their claim is the dilution factor. In the above case, the dilution factor is 50%.

Why does a company dilute its stocks?

• To add new shareholders — A company may simply want to expand the shareholders’ community further. By increasing the pool size, the organization may find better ways to reach out to top investors, employees, or even the public. Sometimes the valuation requirements of a company demand the addition of a particular number of shares to the existing stock options.

In 2016, Tesla announced a 6.8 million shares addition and raised a capital of $1.46 million. The motive behind the issuance was simply raising more capital. Similarly, in 2020 the same company rolled out new 2.65 million shares and received $5 billion in funding, the highest ever in its history.

• Acquisition of new firms or Mergers — When a company acquires another, the new company’s shares automatically get transferred to the old one. This way, the company can eliminate shareholders with a lesser stake and focus on delivering higher dividend options for its employees. When two companies merge their operations, the shares increase in number either to raise more funds or provide better security for their staff. Recently, when Mullen Automotive offered over 51 million shares, the number rapidly increased to 509 million shares after Net Element’s reverse merger. The dilution rate is estimated to be 895%.
• To fulfill the financial needs of a company — Although the dilution may sound troublesome for the investors and shareholders, sometimes, it can turn out to be the right decision for the company, especially if there are debts to be cleared or the need for more investment or develop the infrastructure. But if the investors see a potential rise in the value of company shares, they can consider acquiring more shares.

How does stock dilution affect the shareholders?

Stock dilution can be advantageous or dangerous for the shareholders depending on why the company has issued extra shares. The following are the pros and cons of stock dilution:

Pros

• The dilution can be favourable for an existing shareholder if he considers acquiring more shares. More number of shares accounts for more voting power in the company decisions.
• The overall increase in shares can contribute to more dividends.
• The company experiences an increase in capital due to the extra funds they receive from the new shareholders. The reserves can be used for the development requirements of the business.
• The cost per share decreases as the number of shares increases, and as a result, the risk involved also is low.

Cons

• The shareholders will go through a declined ownership in the company holdings.
• The existing shareholders might lack motivation because of fewer voting powers for smaller shareowners.
• The Earnings Per Share (EPS) goes down as the share quantity becomes higher.
• The dominance of larger shareowners over the ones with smaller shares can sometimes be intimidating.

Example of Stock dilution

Assuming XXX Group of Companies have 50,000 shares and 50 shareholders in total. That means every shareholder possesses 1,000 shares of the company. So the ownership rate of each shareholder is

1,000/50,000 × 100 = 2%

Similarly, after the company issues 10,000 new shares as an outcome of stock dilution, the total number of outstanding shares becomes 60,000, and 10 new shareholders join the existing shareholders’ count. Having 1,000 shares per head, the ownership rate post-dilution would be

1,000/60,000 × 100 = 1.6%

If the company has generated $100,000 in earnings, the earnings per share would be

EPS = $100,000/ 50,000 = $2/share.

Post dilution, the EPS = $100,000/60,000 = $1.4/ share

Summing up

Stock dilution involves a thorough assessment of your company’s liabilities and equity management. To keep track of market trends and scopes in the future can be overwhelming, especially if you are a company owner. We, at Eqvista aim to simplify your equity operations with our expertise in the industry. Have more queries? Contact us today!