What Is Dilution?
Let me explain dilution directly: it happens when a company issues new shares, which cuts down the ownership percentage of existing stockholders in that company. You might see this with stock options exercised by employees or other holders of optionable securities. As the number of outstanding shares goes up, each existing stockholder ends up with a smaller slice of the pie, making each share worth less.
How Dilution Works in Practice
Think of a share of stock as your piece of equity in a company. When the board decides to go public via an IPO, they set the initial number of shares, known as the float. If they later issue more stock in secondary offerings, that increases the float and dilutes the stock. If you bought into the original IPO, your ownership stake shrinks compared to before those new shares hit the market.
Key Takeaways on Dilution
Dilution means a drop in your equity position because new shares are created or issued. It also cuts the company's EPS, which can push share prices down. This often happens when a firm raises more equity capital, and existing shareholders usually end up on the losing side.
Understanding Dilution
Dilution is like slicing the equity cake into more pieces—there are more slices, but each one is smaller. You'll still get your slice, but it's a tinier part of the whole than you expected, and that's rarely what you want. It affects your ownership and reduces EPS (net income divided by the float), often leading to lower stock prices. Public companies often share both non-diluted and diluted EPS estimates to show what might happen if new shares come into play. Diluted EPS assumes those potential securities are already converted.
When and Why Dilution Occurs
Share dilution kicks in anytime a company raises equity by issuing new shares to investors. The upside? The cash from those sales can boost profitability and growth, potentially increasing the stock's value. Existing shareholders often dislike it, so companies might buy back shares to offset the dilution. Note that stock splits don't dilute; they just give you more shares at an adjusted price, keeping your ownership percentage the same.
General Example of Dilution
Suppose a company issues 100 shares to 100 shareholders—each owns 1%. If they then issue 100 more shares to new shareholders, your ownership drops to 0.5%, and so does your voting power.
Real-World Example of Dilution
Companies often announce plans to issue new shares well in advance, giving you time to adjust. Take MGT Capital: on July 8, 2016, they filed a proxy statement outlining a stock option plan for their new CEO, John McAfee, plus acquisitions paid partly in stock. Both would dilute the existing shares, and the statement proposed more authorized shares, signaling even more dilution ahead.
Dilution Protection
You, as a shareholder, typically push back against dilution since it devalues your stake. Dilution protection is a contractual safeguard that limits or stops your ownership from shrinking in future rounds. If the company acts to dilute your 20% stake, they must offer you discounted shares to offset it. You'll find these in venture capital deals, also called anti-dilution protection. Similarly, anti-dilution provisions in options or convertibles protect against later stock issuances at lower prices than what you paid, common in convertible preferred stock for VC investments.
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