Stock dilution
From Wikipedia, the free encyclopedia
Stock Dilution refers to the decrease in the 'ownership percentage' in a company when more shares are issued. The increase in shares outstanding results from the issuance of new shares to the public, from employees exercising their stock options, or by the conversion of convertible bonds, preferred shares or warrants into stocks. Although the ownership% may be reduced, the dollar value of the investment may not be. It depends on the proceeds received by the company in exchange for the new shares. A third issue is the possible dilution in the earnings allocated to each owner. Again, this depends on the proceeds received and the return realized on its investment.
In many venture capital contracts, the investor(s) put in anti-dilution clauses to prevent their equity investments from losing value. One way to raise new equity without losing voting control is to give warrants to all the existing shareholders equally. They can choose to put more money in the company, or else lose ownership %. When employee options threaten to dilute the ownership of a control group, the company can use cash to buy back the shares issued.
Contents |
[edit] Measurement
The metric heard most frequently is a measure of the % dilution". This is calculated as follows:
- Presume that all convertible securities are convertible at the date.
- Add up the number of new shares that will be issued as a result.
- Add up the proceeds that would be received on these conversions. (The reduction of debt is a 'proceed').
- Divide the total proceeds by the current market price of the stock to determine the number of shares it can buyback.
- Divide the net increase in shares (increase on conversion less buyback) by the starting # shares outstanding.
This is a 'point-in-time' measurement that will change as soon as the market value of the shares changes. It cannot be interpreted as a measure of the impact of dilutions. The impact of dilution changes according to the terms of the convertible security.
[edit] Impact of new equity issued
The dilution in value from new equity can be determined from the POV of the company, or from the POV of the investor. If the new shares are issued for proceeds equal to the pre-existing book value per share, then there is no dilution in value from the company's POV.
But quite frequently the market value for shares will be higher than the book value. Investors will lose value unless the proceeds equal the market value per share. When this loss is triggered by the exercise of employee stock options, it is a measure of wage expense. The difference between the book value per share and the market value that would be received as compensation (in a market transaction) is a kind of internalized capital gain for the investor. To see this work consider the example [|here]. The investor is in the same position if the company doubles its shares, as he would be if he sold half his shares in the secondary market, when full market value is received.
This understanding presumes that the company can put to work the proceeds received at a rate of return equal to the pre-existing business. When shares are issued in exchange for the purchase of a business, the incremental income from the new business must be at least the ROE of the old business. When the purchase price includes goodwill, this becomes a higher hurdle to clear.
The flip side of this reality is what happens when companies buy back their own shares from the secondary market. All the above holds true.
[edit] Impact of preferred share dilution
Preferred share conversions are usually done on a dollar-for-dollar basis. $1,000 face value of preferreds will be exchanged for $1,000 worth of common shares (at market value). As the common shares increase in value, the preferreds will dilute them less (in terms of %ownership), and vica verca. In terms of value dilution, there will be none from the POV of the shareholder. Since most shareholders are invested in the belief the stock price will increase, this is not a problem.
But when the stock price declines because of some bad news, the company's next report will have to measure, not only the financial results of the bad news, but also the increase in the dilution %. This exacerbates the problem and increases the downward pressure on the stock, which increases the dilutions, etc, etc. Some financing vehicles are structured to augment this process by redefining the conversion factor as the stock price declines. Thus leading to a 'death spiral'.
[edit] Impact of options and warrants dilution
Options and warrants are converted at pre-defined rates. As the stock price increases, their value increases $for$. If the stock is valued at a stable P/E it can be predicted that the options' rate of increase in value will be 20 times (when P/E=20) the rate of increase in earning. The calculation of "what % share of future earnings increases goes to the holders of options - not shareholders?" is [1]
(in-the-money options outstanding as % total) * (P/E ratio) = % future earnings accrue to option holders
E.g. if the options outstanding equals 5% of the issued shares and the P/E=20, then 95% (= 5/105*20) of any increase in earnings goes, not to the shareholders, but to the options holders.
