Stock Dilution

Publication Date :

27 Mar, 2023

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Table Of Contents

What is Stock Dilution?

Stock Dilution is defined as a decrease in the percentage of the ownership held by the existing shareholders of the company because of the new shares issued by the company, and such a dilution can happen either by offering shares in exchange for funds or can also be due to conversion of dilutive securities like stock options, convertible debt, etc.

Stock Dilution decreases the ownership stake of existing shareholders in a company. An investor can benefit, make losses, or have no change in position depending on the situation. However, the expertise of the investor can make all the difference in the direction of growth of the start-up or even a well-established company.

What is Stock Dilution?

Stock Dilution Explained

Stock dilution is a corporate action that decreases the ownership of the existing stockholders of a company by issuing new stocks in the market. The new stock increases the total outstanding shares in the market, which results in dilution of the ownership of the existing shareholders. An increase in the outstanding shares can result from a primary or secondary market offering, which includes an Initial Public Offering, issuance/conversion of convertible bonds, warrants into stock, and issuance of preferred stock, new stock options, etc.

Common stock dilution may affect the ownership percentage, earning per share, voting rights, and the stock's market value. With the additional flow of shares in the market, even though the ownership gets diluted, the company's valuation increases due to the additional flow of funds by the sale of the new shares.
Simply put, it is an additional issuance of stocks by the company that eventually results in a reduction of ownership stakes of existing shareholders. After dilution, the shareholder is either in bad condition or maybe in a neutral condition; for some, it turns out to be good.

Formula

The formula to use the stock dilution calculator and find the exact number is:

Stock Dilution = Existing shares of an individual/ (Total number of shares + Total new shares)

Examples

Let us understand the concept in detail through the calculations and examples below.

In the examples below, the three primary sources of stock dilution calculation have been explained

'Mber Inc' is a design and engineering startup with a new coffee mug that customizes the drinking temperature of coffee or tea. Year ending 2018, Mber had common stock of 100,000 shares with a market capitalization of $1 million and $100 of net profits. Merry Andrew is an individual investor who bought 10,000 shares of Mber on 31st Dec 2018. So when the company announced its earnings, Merry was merrier to know that his investment has earned $10 of Mber's profits.

#1 - Stock Dilution through Issuance of New Shares to Employees

In 2019, Mber issues 100,000 stock options to its CEO. As of now, it has an outstanding share of 100,000 shares. But eventually, when the CEO exercises the stock options, Mber will have a diluted share count of 200,000 shares.

Well, after this, nothing is merry for Merry, our investor. He still owns 10,000 shares, and once the company issues the additional stock, his ownership stake will be diluted. The initial outstanding share count was 100,000, and the profit earned was $100; Merry was entitled to $10 of the profits, which were 10% (10,000 / 100,000). After the issuance of the additional shares in the market, Merry's ownership will not be 10% but would topple to 5% (10,000 / 200,000) of the total outstanding shares, which means, for every $100 profit, Merry would only earn $5. Don't you feel bad for Merry? The CEO just got lucky with this move; he gets his hands on 50% (100,000 / 200,000) of company shares.

#2 - Issuance of New Shares for Expansion

Let's assume Mber wants to expand its business, but the temperature control mug is yet to be a hit among the masses. That is a problem! The management thinks the solution to this problem is to buy out its rival, Vecup. Since Mber hasn't sold any of the mugs and has no money to make a move, it would exchange its shares to Vecup shareholders. Confused?

Breaking it down: Mber will take ownership of Backup in exchange for new shares issued in the market. Vecup, a massive player in the market, has a market capitalization of $20 billion, and Nber having a market value of $10 per share, will need to make an issuance of 2 billion new shares to crack this deal. This will dilute the ownership of its existing shareholders, including Merry, by 200,000 times. Looking at the larger picture, Merry's cut from the profit after the merger of Member and Vecup looks much smaller than his cut from the profit of Member alone. But the net profit would be much bigger. This is because merry would receive a small share from a bigger profit of Member and Vecup in exchange for his original investment of a big share from a small profit. Simply put, it is a smaller piece out of a bigger cake.

#3 - Secondary Offering

Stock Dilution can also be done by secondary issuance. When Mber issues 100,000 shares to its CEO, the shareholders are impacted negatively since it is offered at a nominal price. Before the management issues the new shares to the CEO, Member starts to make it a hit among the masses with the cutting edge technology and the state-of-the-art service to its customers. Member's share a burgeon and sell the additional 100,000 shares at $500 per share. If the share price has increased without changing its intrinsic value, Merry will be merrier than ever.

Members' worth increased not just because of the mass popularity, but the intrinsic value of the company increased as it traded $50 million for the 100,000 additional shares that were issued in the market. As a result, merry's 5% stake, i.e., 10,000 shares out of 200,000 shares, now has a whopping $2.5 million value.

Advantages & Disadvantages

Let us understand the advantages and disadvantages to fully understand the concept of a common stock dilution through the discussion below.

Advantages

For an organization that wants to reduce external ownership, dilution helps increase internal ownership by issuing additional stocks to its employees.
Even if the shares are issued in the open market, the company's valuation increases in the market with the additional inflow of funds made by the increase in the outstanding shares.
When a company issues shares priced higher than the intrinsic value, an external shareholder will always benefit without diluting the ownership stake.

Disadvantages

Investors hate dilution as, in most cases, it represents a transfer of ownership from external shareholders to insiders.
Reduces the ownership stake of existing shareholders;