When a business, corporation, or company decides that it will issue more shares of its stock, this can potentially reduce the value of shares held by its existing investors. This issue is known as share dilution, also sometimes called stock dilution. Share dilution is a risk that investors by ve wary of when they choose to become shareholders with a company. Here is the share dilution meaning explained.
What is share dilution?
Now that we understand how it works, what is the share dilution definition? Share dilution is defined as the reduced or diluted ownership in a company’s stock for its preexisting shareholders when that company decides to issue fresh stock. As an example of share dilution, consider the following. Let’s assume that a small company has a total of ten shareholders with each shareholder owning 10% of the company. If all these particular shareholders receive the voting rights to make decisions, they each would exercise 10% control.
Now let’s say that the company decides to issue ten new shares and one single investor chooses to buy all of those shares. Now the same company has a total of 20 outstanding shares, with a single investor who has a 50% stake in the company. On the other hand, every original investor will now exercise 5% control in the company’s decisions because their ownership has been diluted by the issuance of new shares. This is stock dilution.
How do stocks become diluted?
The aforementioned example is not the only way in which shares can become diluted. Several situations can arise that can force shares to become diluted. These situations are as follows:
Share conversion by those who hold optionable securities: Some shareholders have the option, depending upon the company they have invested in, to convert their shares into common stock. This boosts the number of total shares issued by the company and causesstock dilution.
Secondary offerings with the goal of raising extra capital: Another reason a company may issue additional shares is that they are looking to raise new capital to fund their growth opportunities. This may also be with the goal of paying off any pre existing debt. Whatever the reason to raise capital, this method does result in stock dilution.
Shares offered by the company in place of new acquisitions or services: If a company is purchasing a new firm, it may offer the shareholders of that firm new shares in its company. In exchange for the services they provide, some small businesses also sometimes offer shares to the individuals they offer these services to.
Impact of Share Dilution
Stock dilution has some effects. Unfortunately, it is not viewed in a very positive light by many shareholders. The reason behind this is, after all, that with more fresh shares added to the pool of pre-existing shares, the ownership a shareholder has in a company is being reduced. This may lead to shareholders believing the share dilution is associated with their value in the company reducing. There is also the fact that in certain situations, those investors who possess a large number of stocks can take advantage of the shareholders who have, as a result of stock dilution, smaller ownership in the same company.
Keep in mind, however, that share dilution is not that bad of an outcome for a shareholder. In some cases, when a company has made the executive decision to issue fresh stock, this can be a sign that it has likely boosted its revenue. This is a positive outcome. Another more optimistic reason why a company may go ahead and issue more shares is that it might be buying out a competitor, opting for a strategic partnership, or investing in a new product. This may boost the value of its stock in the long run, even if it temporarily dilutes the stock.
The Bottom Line
Share dilution usually occurs whenever a company decides to issue new stock to fresh investors. The effect is share dilution can drastically affect the value of your financial portfolio. In fact, a company is required to make adjustments to its earnings/share as well as the ratio denoting its valuation whenever share dilution occurs. While share dilution is usually looked at in a negative light, it can also be a positive sign of a new acquisition that could lead to boosted stock performance in the future. Investors should still keep an eye out for the warning signs of stock dilution so they are not blindsided when it occurs.
