What is stock dilution and why do companies try to avoid doing it?
Understanding stock dilution
What is stock dilution?
What do you think when we say the word dilution? Let us say that you have a liquid syrup. You put water or another solvent, and it becomes thinner. This analogy can also happen to stocks. Hence, we call it "stock dilution" when a company adds more outstanding shares to reduce the existing shareholders' ownership percentage. The companies that will most likely do this are the distressed ones. And when we say distressed, those with financial difficulties at the moment. However, doing so does not always lead to positive results. Why? It is because the owners are also the shareholders. So, everything that lessens the investor's ownership also reduces his holdings.
Companies have different ways of announcing the dilution of shares. Most of them do so during an investor call, or they are in a new prospectus. If this ever happens, there will be more company share. Dilutive stocks are what we call the more recent shares.
Secondary offering and stock dilution
Let us say that Company A has 1,000 shares of float, and it issues 1,000 more shares in the secondary offering. They end up with 2,000 outstanding shares. If this is the case, it will leave the owners with 50% dilution factors. Furthermore, the owner with 100 shares currently has 5% instead of 10% of the company.
When we say dilution, it does not automatically mean that the investment's dollar amount will change. It only means that the investor's influence in company decisions will decline because the shares he holds are now smaller. The stake shows us the declined percentage of the total company earnings.
Shareholders would typically shrug off the idea of secondary options because of dilution. However, an offering gives the company more capital which can massively help in restructuring, paying debts, and investing in R&D or research and development. If we think about it, a secondary offering that will provide capital can also be a great help in the long run for investors, provided that the company improves in its profitability and the stock price increases.
Let us talk about derivatives instruments. Once exercised, they will be exchanged for stock shares issued by the company to employees. Hence, we call them employee stock options, and they are granted in place of stock bonuses or cash. They are like an incentive. Next, we have options contracts. Once exercised, they will be exchanged for shares. Then, the employee can sell those in the market. This action dilutes the company's outstanding shares. The employee stock contract may be one of the most common ways to dilute shares through derivatives. However, convertible debt and equity, warrants, and rights can cause dilution as well sometimes.
What are convertible debts and equity?
We mentioned convertible debt and equity earlier, but what does it mean? A company issuing a convertible debt gives the debt holders an option to convert their securities into shares. This will dilute the shareholders' ownership. Convertible debts will most likely convert common stocks at a specific preferential conversion ratio. For instance, every $1,000 convertible debt converted to 100 common stocks lessens the total ownership of the stockholders.
As a summary
Dilution is when a corporate action such as secondary offerings raises the number of outstanding shares. Exercising stock options can also be dilutive to shareholders if it increases the number of outstanding shares. Also, dilution lessens every stakeholders' stake in the company. However, it is essential to do if the company's capital for operations is not enough. Convertible debt and equity are also dilutive as the securities are converted to shares.