Definition of Stock Dilution
Share dilution refers to the situation when the existing shareholders of the company losses the ownership of the percentage of their holdings in the company due to the issue of new stock by the company as new issue results in the increase of the company’s share capital, specifically its outstanding shares in the market thereby reducing the value of the existing shares of existing shareholders or the reduction in the value of ownership of shareholders in the company.
As per the literal meaning of the word, “dilute” means the decline. Hence stock dilution also refers to the decline in the number of stock of the existing shareholder’s ownership in the company. Share dilution generally takes place because the company increases the number or volume of its existing shares by the issue of new shares in the market. By the issue of new shares in the market, the ownership of the existing shareholders gets decreases. The issue of new shares in the market is done by many forms or reasons like employee stock options, issue of shares to the investors, management or other key persons of the company.
How Does It Work?
The share dilution of the company increases the company’s issued capital, thus reducing the ownership of existing shareholders. The previous issue of shares is already in existence at the time of this second issue of the stock in the market. There are various different factors that cause the company to go for the dilution of stock. In many companies, when the employees perform exceptional or good, the company gives them the reward in the form of shares of the company in order to appreciate their work or performance. When those employees exercise their option in the market, the number of shares issued by the company gets increased, and hence automatically, the percentage ownership of the existing other shareholders get reduced. Hence, the share capital of the existing shareholders gets diluted, and hence the process is stock dilution.
Example of Share Dilution
Let’s consider the company ABC ltd. The issued share capital of the company ABC Ltd is $100,000, which is given to 100 shareholders at the price of $1000. Each shareholder of the company own 1% (1/100*100) holding in the total issued share capital of the company. The company is now again proposing to issue the same volume in the market as it has earlier issued 100 shares at a price of $1000.Here the total number of the issued share capital of the company increases by $100,000, making the issued share capital of the company doubled, i.e. $200,000.
% of holding of existing shareholder before new shares issue
|Total share value||$100,000.00|
|Value of shares held by each shareholder||$1,000.00|
|% of holding by each shareholder||1.00%|
% of holding of existing shareholder after new shares issue
|Total share value||$200,000.00|
|Value of shares held by each shareholder||$1,000.00|
|% of holding by each shareholder||0.50%|
As we calculate the % holding of the new shareholders in the company, it now reduces to 0.5% from the previous 1% of the new issue of shares, in which case the total number of share capital gets doubled. Hence, here we can see the Dilution of the 0.5% of the % ownership of the existing shareholders in the company by the issue of new shares in the market, which is called the share dilution.
How to Stop Stock Dilution?
The following are the some of the ways to stop Stock Dilution:
- There is the special right given to the company’s shareholders to have the protection against share dilution, which is called the right of pre exemption. In this, the company’s shareholder has the right to refuse the first share issued by the company to prevent a reduction of the percentage ownership in the company.
- There is no other right given to any shareholder other than pre exemption to avoid the dilution of the stock of the company.
- The Stock dilution limit has to be mentioned by the company in its article of association or other legal documents.
Impact of Stock Dilution
The following are the some of the impacts of stock dilution:
- There is a negative impact of stock dilution on the shareholder of the company. Because there is a reduction in the value of shares the shareholders hold.
- Also, the number of the issued capital of the company gets increase due to the new issue of shares in the market.
- The company’s future earnings get increased because the money earned by the process of the new issue of shares in the market is kept aside by the company, and this earning of the company can be used for any special purpose and for any future project.
Dangers of Stock Dilution
There are some of the dangers of stock dilution:
- As there occurs the decrease in the ownership of the existing shareholding of the shareholders in the company, they lose the motivation of being there in the company. Hence there is a danger of losing the existing shareholders of the company when there is stock dilution in the form of a new issue undertaken by the company.
- The new issue of the shares by the company, which results in stock dilution of the shareholder of the company, is viewed as the deteriorating financial health of the company. Hence, it puts the wrong image in the eyes of the investors, along with many questions as to why suddenly the company went for the issue of new shares in the market. Also, it the company losses its present investors too.
The stock dilution of the company cannot be stopped or prevented by the shareholders of the company except the pre exemption right. However, a company can have different rights and regulations with regards to the stock dilution. The company’s minimum and a maximum number of new shares in future in terms of specific limits should be mentioned in the articles of association of the company and in its other legal documents so that the basic rights of the shareholders in the company should be prevented. The shareholders of the company should have all the knowledge and information of every new issue undertaken by the company, along with the forms and ways of the new issue of shares by the company.
This is a guide to Stock Dilution. Here we also discuss the definition and how does it work? Along with impacts of stock dilution. You may also have a look at the following articles to learn more –