Stock dilution is when companies issue new shares. The issuance of the new shares dilutes the ownership stake of the existing shareholders. It’s because the same net assets of the company are divided among a more number of the shareholders.
But, the question arises why the companies opt for the issuance of stock. Well, there can be several reasons for dilution of stock, including the following.
1) Capital needs of the company
The company may find some feasible investment opportunities. An opportunity may be in purchasing the business, acquiring some business operations, developing some products, or increasing their capacity of operations, buying out competitors, etc.
However, the business may not have sufficient funds to proceed with the financially feasible investment opportunity. So, the business may raise the finance via equity financing.
The business may have other options to opt for financing. For instance, raising finance via debt. However, there may be some reasons like maintenance of the financial leverage that suggest the business should raise finance via equity to bring stability in the financing structure.
Although, raising finance with the debt can be cost-effective on account of tax advantage. Still, there is some threshold to remain in the sphere of the tax advantage because if the proportion of debt is massive, it might lead to a higher cost of financing than the equity.
Hence, the businesses may decide to opt for equity financing that might dilute the existing shareholder’s stake of the ownership.
2) Expanding the base of the shareholders
Sometimes, the companies want to expand their base of shareholders. The companies with a broader range of shareholders are considered to be stable. Further, some of the exchanges require a specific number of shareholders to grant a listing for the trading.
So, the business has the potential to increase the base of the shareholders when they raise equity.
3) Issuance of convertible options to employees to align the interest
The companies grant convertible options to the board members and employees. These options are granted to align the interest of the employees and of the shareholders. This encourages the board and employees to make the decision in the best interest of the shareholders.
The holders of the options exercise their right once the valuation of the company’s stock increase above the conversion price; the option is exercised, which may lead to the dilution of the stocks for existing shareholders.
It’s important to note that the companies usually grant convertible options to the executive as they have decision-making power and higher wages. Paying with the convertible options also helps the business to lower the need for cash as executives need to be paid higher wages.
4) Enhancement of internal ownership
If the company wants to reduce external ownership of the shareholders, they might issue convertible options to internal stakeholders (employees). When these options are exercised, it leads to dilution on the ownership of the external shareholders. Hence, the purpose of the company is achieved.
5) Enhanced valuation
Sometimes, the companies want to increase the size of capital that impacts the valuation. The business may require the enhanced valuation for different reasons, including compliance and meeting the criteria of the financial institutions to sign a deal with them.
Pros of the stock dilution
Following pros can be associated with the issuance of the stocks.
- Stock dilution helps to reward the employees and managers of the business. It helps to develop the perception that business is growing and there is enhanced stability. So, an increase in the internal ownership of the company is considered a sign of a productive working environment. Hence, it seems to be a value-adding scenario for the company.
- If the company sells new shares at a price that is higher than the current valuation of the shares, it’s an ultimate benefit for the shareholders as they experience an increase in the stock price.
- Additional inflows of the cash lead to an increase in the valuation of the company.
Cons of the stock dilution
Following cons are associated with the issuance of the stocks.
- Existing shareholders of the company may not be happy with issuing new shares as it dilutes their ownership stake.
- Suppose the company has a trend of raising finance with the stock dilution. It may not be a good signal for the market, and investors might perceive that the company does not seem to be financially fit and has to raise the short term finance from time to time. So, they might decide not to invest in the company.
- An investor perceives stock dilution as an immediate loss against risk presumed by the business. In simple words, the company raises the finance for some business opportunity and presumes the risk for the return, which may/may not be achieved. But, investors have already faced the loss in the form of reduced ownership for the return that might never be achieved.
- The stock dilution might impact the percentage of the shareholdings, right to vote, and then power of the decision making, etc.
Stock split VS stock dilution
The stock split is when the company issue more stock to the same shareholders in the same proportion of the ownership. A stock split does not modify the ownership stake of the existing shareholders. The companies split the stock in order to decrease the per-unit price of the share to make it more affordable for the people to buy.
On the other hand, stock dilution is when the company issues shares with obtaining finance. Stock dilution leads to a reduction in the ownership stake of the existing shareholders.
Bottom line
The companies raise the finance by issuing additional shares. It helps the business fulfill capital needs, expand the base of the shareholders, issue convertible options to the shareholders, enhance internal ownership, and enhance the company’s valuation.
However, there are some concerns about raising finance with the stock dilution. For instance, shareholders of the company may not be happy with the dilution because it reduces their power to make the decision and direction of the business.
Frequently asked questions
What is the impact of the stock dilution on EPS?
The dilution of the stock increases the number of shares issued by the company. This results in the distribution of the earnings among a more significant number of shareholders. Hence, the stock dilution leads to a decrease in the EPS.
We also need to understand other perspectives of the dilution in EPS. Suppose dilution of the shares was made to expand operations of the company. The success of the operations may lead to a massive increase in the profit of the company. Hence, increased profit may lead to an overall increase of the EPS than before stock dilution.
What’s the opposite of the stock dilution?
The opposite of the stock dilution is the repurchase of the shares from the market. Its impacts are usually opposite of the stock dilution as share repurchase signals to the market that the business’s financial condition is strong enough and the company is about to do something great in the near future.
How does dilution of the shares impact the stock price of the company?
Dilution in the stock of the company usually leads to a decrease in the price of the shares. Basically, the sentiments of the market determine the price of the shares and dilution leads to adverse effects on the sentiments of the market.
Is equity dilution the same as stock dilution?
Yes, Equity dilution is the same as stock dilution.
What is protection against dilution?
Dilution protection is a contractual provision that restricts the corporation’s power to raise the finance and reduce the stake of the investor if the company decides to go for the second round of funding.
Can investors protect themselves from stock dilution?
Pre-emption rights can act as great immunity for stock dilution. Pre-emption right refers to the contractual right for the acquisition of the shares in preference. Further, there may be some provision in the article that restricts the company from diluting the stock.
