Dilution is the reduction in the ownership percentage of a company, or shares of stock, due to the issuance of new equity shares by the company, when you hear the term used on Wall Street. We all know what dilution is; you are probably doing it as you read this article by adding cream to your coffee to dilute the strength. Dilution of companies also occurs when holders of options, such as the owners, top executives or holders of classes of convertible shares exercise their option to buy more stock. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.
Share dilution may happen any time a company needs additional capital, seeing as new shares are issued on the public markets. The potential upside of share dilution is that the capital the company receives from selling additional shares can improve the company's profitability and the value of its stock. They also may issue these new shares to help with the overall cash flow of the day to day running of the business; or an overall long term goal such as the hostile takeover of a competitor.
However, share dilution is not normally viewed favorably by existing shareholders. Let me give you an example of XYZ company that issued 100 shares to Shareholders. Each of the 10 board members have an option to purchase 100 additional shares at future price of the stock at one point in the future. XYZ stock sells for $1 a share. The Options can be exercised at $5 a share 1 year from now November 2019. XYZ company sells the 100 shares to 100 individual investors, in turn means each investor owns 1% of the company. One year later in 2019 the shares are selling at $10 a piece and Joe board member decides to exercise his right to buy 100 shares at $5 each because he will profit on the $5 (5-10) increase in his share price When he does this (he owned no previous shares) he now owns 50% of the company 100 shares while each initial stock holder now owns only 0.05% of the company instead of 1% since there are now 200 shares outstanding.
Another example would be if the company decides to issue 100 additional shares through another offering, existing shareholders then have the option to purchase these shares in the new offering to avoid the dilution. Companies often issue what are termed "Rights" or the right to buy the new shares to avoid dilution.
This does not effect a stock split enacted by a company. In situations where a business splits its stock, current investors receive additional shares, keeping their percentage ownership in the company exactly the same. In this case with a 2 for 1 stock split on XYZ each holder of 1 share of stock would now have 2 shares at $5 apiece instead of 1 share worth $10 apiece.
You may hear discussion in the coming weeks over at Tesla (TSLA) about dilution it is looking as if the company will not be able to avoid this as it is running into walls with cash flow issues. This is not to say that Tesla is in trouble financially or if you hold the security to sell; but just that they may not avoid this event from happening as they move through their next business cycle.
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