Dilution In Trading: Crucial Concept Which You Should Know?

Whether you are a retail investor, someone’s financial portfolio manager or a company owner, dilution in trading is an essential concept to be aware of.

Dilution affects a shareholder’s ownership in a company. Though it can reduce an existing shareholder’s ownership percentage, this isn’t always a bad thing; it all depends on the context – the reasons behind the dilution and how the new capital is utilised.

In this article, we will learn more about stock dilution, how it works, why it occurs, and the safeguards available to investors.

• Table of contents

• What is Dilution
• Working of Dilution
• Causes of Dilution
• General example of dilution
• Protective Measures for Dilution

What is Dilution

Stock dilution happens when a company issues additional shares of stock, which reduces the ownership proportion of existing shareholders. This is because when more shares are added into circulation, each shareholder ends up owning a smaller percentage of the company.

For example, if a company has promised shares to employees or others in the future (through stock options), and those people choose to take the shares, the total number of shares in the market increases. This can reduce the ownership percentage, and potentially the value of shares already held by existing investors.

Working of Dilution

A share of stock means you own a small part of a company. When a company decides to go public, usually through an IPO (initial public offering, its board of directors approves a certain number of shares to be sold. These available shares are known as the ‘float’.

Later, if the company decides to release more shares (called a secondary offering), it increases the total number of shares available. This can potentially reduce the value of existing shares and diminish the ownership percentage of existing shareholders. This process is known as stock dilution.

Read Also: What are stocks?

Causes of Dilution

A company can opt for stock dilution for multiple reasons.

• Raising money for growth or paying off debt: Sometimes companies issue extra shares to raise money. This money can be used to help the company grow its operations, invest in a strategic asset, or be used to pay off loans.
• Buying another company: When a company wants to buy another business, it may offer new shares to the other company’s shareholders as payment.
• Giving stock options to employees: Companies often give stock options to employees as part of their salary or benefits. When employees use these options and turn them into actual shares, the total number of company shares increases.
• Paying service providers with shares: Smaller companies may not always have cash to pay for services. In such cases, they might issue shares.
• Issuing warrants or convertible securities: Companies might also give out warrants (rights to buy shares later) or convertible bonds (bonds that can turn into shares).
• Using dilution as a strategy: Sometimes, large shareholders may use share dilution on purpose for either reducing the power of smaller shareholders or to pressure them into agreeing with corporate decisions they might usually oppose.

General example of dilution

Let’s understand dilution in trading through a simple example. Let’s suppose a company issues 10,000 shares through an IPO and you purchase 1,000 shares. You will have 10% ownership in the company. Now, if the company decides to issue 5,000 more shares, the total number of the company’s shares in the market would be 15,000. Here, your ownership will reduce to 6.67% (1,000 / 15000) even though the number of shares you hold has not changed. (For illustrative purposes only)

Protective Measures for Dilution

• Shareholders usually dislike dilution as it reduces the value of their ownership.
• Dilution protection (or anti-dilution protection) is a contract clause that potentially safeguards investors from losing ownership percentage during new funding rounds.
• If a company issues new shares, existing investors with this protection may be offered discounted shares to maintain their stake.
• For instance, if an investor owns 20% and new shares are issued, they may get extra shares to mitigate the impact of dilution on their ownership percentage.
• Anti-dilution clauses are common in venture capital deals, especially with convertible preferred stock and convertible securities.

Read Also: What is Scalp trading?

Conclusion

To sum up, stock dilution refers to the reduction in ownership percentage that occurs when a company issues additional shares. This can potentially impact voting rights, earnings per share, and overall share value.

FAQs:

What is dilution in stocks?

Dilution in stocks refers to a decrease in the ownership percentage of existing shareholders due to the company issuing new shares.

When does dilution happen?

• Raising money for growth or paying off debt
• Buying another company
• Giving stock options to employees
• Paying service providers with shares
• Issuing warrants or convertible securities
• Using dilution as a strategy

How does dilution affect EPS?

Earnings per share (EPS) is calculated by dividing a company’s net income by its total number of outstanding shares. If net income stays the same, this can potentially results in a lower EPS, which can make the company appear less profitable on a per-share basis.

What are anti-dilution provisions?

Anti-dilution clauses are common in venture capital deals, especially with convertible preferred stock and convertible securities.

Can dilution ever be beneficial?

Yes, stock dilution can be potentially beneficial when the capital raised is used wisely––such as for investing in innovation, acquiring a strategic asset, or reducing debt.