Demystifying Share Dilution and Its Effects on Stock Prices
You’ve likely heard of companies diluting shares, but what does that mean? Learn about the share dilution process and how it can affect your stock prices.
When companies issue more shares of stock, one possible effect is reducing the value of existing shares — this is called dilution.
As shareholders, investors must understand how share dilution happens and what it means for them. While the concept might seem confusing, we’ll break down how share dilution can affect stock prices.
What Is Share Dilution?
When a company issues additional stock, it reduces (dilutes) the shareholders’ ownership in the company.
For example, assume a business has 20 shareholders, and each one holds one share. So, each shareholder owns 5% of the company. And if those shares come with voting rights, each investor would have 5% control.
Then, that company issues 20 new shares, which are sold to a single person. Just like that, that person owns 50% of the company. So, what happens to those 20 previous shareholders? They now only hold 2.5% of the company because the 20 new shares diluted their ownership.
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How Do Shares Get Diluted?
Share dilution can reduce an individual’s investment; investors should understand warning signs that may lead to a company issuing new stocks and diluting current shares.
Several situations can lead to share dilution.
Company’s Raising Capital
A common reason shares become diluted is that companies don’t have enough cash to pursue their projects; they decide to issue new stock to raise investment capital. This process works differently depending on whether it’s a public or private company.
Public companies can choose to raise money with a secondary offering, which happens after its initial public offering (IPO). This follow-on public offering (FPO) provides an influx of money from the new shares issued.
However, this dilutes existing shares and can negatively impact existing stockholders — especially if the company doesn’t have a solid plan to use those new funds for future growth.
On the other hand, private companies can raise capital with a priced funding round. Investors receive new shares in exchange for offering the business money to continue growing. This process also dilutes existing shares.
Employee’s Exercising Stock Options
Employee stock options give individuals the right to buy a specific number of shares at a certain price. Businesses offer these programs as part of compensation packages to attract the best talent in their industry.
When an employee exercises that option, they receive common shares, increasing the number of outstanding stocks; however, this affects share dilution differently, making it challenging to predict exactly how employee stock options impact overall dilution.
An important note about equity compensation, like employee stock options, is that they usually come with a vesting period, meaning that if they leave the company before their options vest, they can’t purchase those shares.
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Company’s Acquiring Other Companies
Share dilution can also happen when companies purchase or acquire another business — for example, part of the acquisition deal may require the company to issue additional shares to stockholders of the company it is acquiring.
Similarly, some small businesses will offer new shares to people in exchange for their services, resulting in share dilution, albeit on a smaller scale.
Company’s Converting Securities
Some startups fund their growth by issuing convertible securities (convertible notes, SAFEs, etc.). Although these securities work in different ways, they are all short-term instruments that allow investors to convert them into shares of the company in the future.
When that conversion happens, those stocks contribute to the total outstanding shares, resulting in dilution. Just look at what happened with MARA recently — the company announced it would issue over 26 million new shares, resulting in a significant drop in its valuation.
How Does Share Dilution Affect Stock Prices?
Most existing stockholders don’t view dilution as a positive thing — when more shareholders join the pool, current investors own a lower percentage of the company. Share dilution can cause shareholders to believe that they are losing the value of their investment.
While dilution causes stock prices to drop, it isn’t always bad. For example, if the company issues new stocks to boost revenue or start a new venture that leads to more profit, it can be beneficial for current shareholders.
So, Is Share Dilution Bad for Stockholders?
As we mentioned above, existing stockholders tend to hate the words “stock dilution,” interpreting it as a sign that the value of their shares will decrease. And that is a real possibility.
Without considering any other aspects of investing, decreasing how much you own of something decreases the value of what you own. One thing many investors dislike about stock dilution is that it results in diluted earnings per share — a metric used to evaluate the profitability of a business.
However, the impact of stock dilution doesn’t happen in a vacuum, and there’s more than the monetary value of shares at stake. In many cases, owning a large portion of a company’s shares comes with voting rights, among other benefits.
With that said, share dilution isn’t necessarily bad for investors — as long as it happens for good reasons. If the money raised by issuing new shares improves a company’s growth and profit, it can benefit everyone.
Isn’t owning 5% of a pizza better than owning 10% of a slice?
Is There Any Protection Against Share Dilution?
Many shareholders typically resist share dilution — it devalues their existing equity. However, some investors can protect their stock’s value with anti-dilution provisions. Dilution protection may be included in a contract, preventing or limiting their stake in a company during later funding rounds.
Another way that dilution protection can work is when the company guarantees investors the ability to buy an amount of discounted shares during funding rounds to make up for the dilution. Similarly, there are anti-dilution clauses that can protect investors from dilution if the company issues new shares at a lower price than early investors originally paid.
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