Stock Dilution

Stock dilution, also called share dilution, is the reduction in each existing shareholder's proportional ownership of a company that follows when the company issues additional shares. Ownership is a fraction (your shares divided by all shares outstanding), so any new share added to the bottom of that fraction shrinks it, along with each holder's share of votes, earnings and future dividends. The SEC's investor glossary describes dilution as "the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock." Whether the holder is also worse off in dollars depends on the price: shares issued at fair value bring in cash or assets worth what they cost, leaving the value of each share unchanged, while shares issued below fair value hand part of the existing holders' value to the new ones.

Where the new shares come from. A public company dilutes when it sells new shares in an offering, when employees' stock options are exercised or restricted stock units vest and are settled in shares, when convertible bonds or preferred stock convert, when warrants are exercised, when it pays for an acquisition with its own stock, and when it sells shares privately to investors in a PIPE offering, which the SEC notes can potentially dilute the value of existing shares as the new supply reaches the market. A private company dilutes with every funding round, which is why a founder or early employee who owned 10 percent at the start can own far less by the time the company goes public, even while the stake becomes more valuable. Companies sometimes buy back shares to offset the dilution from employee equity.

The fully diluted count. Shares outstanding is what exists today. A fully diluted count adds every share that outstanding options, warrants and convertible securities could create if exercised or converted. Diluted earnings per share applies that idea to profit, spreading earnings over the larger count.

The prospectus meaning. SEC Regulation S-K uses "dilution" in a narrower, technical sense. Item 506 requires certain registrants offering common stock, including those with losses in each of their last three fiscal years whose offering causes "a material dilution of the purchasers' equity interest," to disclose net tangible book value per share before and after the offering and "the amount of the immediate dilution from the public offering price which will be absorbed by such purchasers." That figure measures how much less book value per share an IPO buyer gets than the price paid; the rule singles out the case where insiders paid far less for their shares than the public price. It is a different number from the ownership dilution existing holders experience.

Small companies and crowdfunding. For an investor in a private or very small company, dilution is often the main risk after failure itself. The SEC's crowdfunding rules require an issuer's offering statement to explain how the rights of the securities offered "may be materially limited, diluted or qualified by the rights of any other class of security" and to describe "the risks associated with corporate actions including additional issuances of securities." Some investors negotiate contractual protections, such as a right to buy into later rounds, and a rights offering gives existing public holders a chance to keep their percentage by buying their share of new stock.

The arithmetic always has two parts: what happens to the percentage, and what happens to the value per share.

For example: a company has 1,000,000 shares and is worth $50,000,000, or $50 a share. Ines owns 10,000 shares, which is 1 percent of the company and worth $500,000. The company issues 250,000 new shares, so 1,250,000 shares are outstanding and her stake falls to 0.8 percent (10,000 divided by 1,250,000) either way. What changes with the price is her dollars. If the new shares sell at $50, the company raises $12,500,000 and is worth $62,500,000, which is still $50 a share, so her stake is still worth $500,000. If they sell at $30, the company raises only $7,500,000 and is worth $57,500,000, or $46 a share ($57,500,000 divided by 1,250,000), and her stake falls to $460,000. In the first case she was diluted in ownership only; in the second, she also lost $40,000 of value to the new buyers.

Pros

• Issuing shares lets a company raise money without borrowing, which can fund growth that makes a smaller stake worth more.
• Paying employees partly in equity can preserve cash for the business.
• Dilution at fair value leaves the value of each existing share intact, whatever it does to the percentage.

Cons

• Each holder's share of votes, earnings and dividends shrinks with every new share.
• Shares issued below their worth, such as cheap employee grants or a discounted offering, move value from existing holders to new ones.
• Steady issuance for employee pay can quietly erode per-share results, and offsetting it with buybacks costs the company cash.
• In a private company, later investors may negotiate terms that leave earlier holders, including employees, more diluted than the headline numbers suggest.