Trading Skills

What is stock dilution?

Stock dilution occurs when a company’s actions increase the number of outstanding shares and therefore reduce the ownership percentage of existing shareholders. Although it is relatively common for distressed companies to dilute their shares, the process has negative consequences for one simple reason: the shareholders of the company are its owners, and anything that reduces the level of investor ownership also reduces the value of the shares held by investors.

Dilution can occur in a number of ways, and corporate actions that dilute stock are usually announced on investor conference calls or in new prospectuses. When this happens, the number of company shares increases, and the newer shares are “dilute shares.”

secondary issue

For example, if a company has a total of 1,000 shares outstanding on the market, and its management issues an additional 1,000 shares in a secondary offering, there are now 2,000 shares outstanding. Owners of the first 1,000 shares will face a 50% dilution factor. This means that the owner of 100 shares now owns 5% of the company instead of 10%.

key takeaways

  • Dilution occurs when a corporate action (such as a secondary offering) increases the number of shares outstanding.
  • Exercising stock options results in an increase in the number of shares outstanding, thereby diluting shareholders.
  • Dilution reduces each shareholder’s share in the company, but is usually necessary when the company needs new working capital.
  • Convertible debt and equity can be dilutive when these securities are converted to equity.

Dilution does not necessarily mean a change in the amount invested, but because of their smaller shareholding in the company’s total share, investors have less influence over the company’s decisions and their stake as a percentage of the company’s overall earnings declines.

While news of a secondary offering is generally not welcomed by shareholders due to equity dilution, an offering can inject capital needed to restructure a company, pay down debt or invest in research and development. Finally, if the company becomes more profitable and its share price rises, getting capital through a secondary offering could be a long-term boon for investors.

exercise options

When exercised, certain derivatives will exchange shares issued by the company to its employees. These employee stock options are typically awarded instead of cash or stock dividends and act as an incentive. When the option contract is exercised, the option is converted into stock, which the employee can then sell on the market, diluting the company’s number of outstanding shares. Employee stock options are the most common way of diluting stock through derivatives, but warrants, rights, and convertible debt and equity are also sometimes dilutive.

Convertible Debt and Convertible Equity

When a company issues convertible bonds, it means that debt holders who choose to convert their securities into stock will dilute the ownership of current shareholders. In many cases, convertible debt is converted into common stock at some favorable conversion ratio. For example, every $1,000 of convertible debt can be converted into 100 shares of common stock, reducing the current shareholder’s total ownership.

Convertible equity, commonly referred to as convertible preferred stock, is usually converted into common stock at a favorable rate. For example, each convertible preferred share can be converted into 10 shares of common stock, thus also diluting the ownership of existing shareholders. The impact on investors who held common stock before dilution is the same as in a secondary offering because their ownership percentage in the company is reduced when the new shares are listed.

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