Dilution is a natural part of the corporate investment process, whether one invests in a startup or a public company that is growing. This article will provide a brief introduction to what dilution is, what causes it, and what effect it has on shareholders.
What is dilution? Dilution refers to the reduction in a shareholder’s proportional ownership percentage in a company as a result of the issuance of additional shares. With the decrease in proportional ownership percentage, each shareholder’s voting rights also take a hit. The increase in the total number of outstanding shares leaves each shareholder with a smaller slice of the same pie. For example, let’s say that Company A that has 100,000 shares outstanding announces a secondary offering of 5,000 shares. The additional 5,000 shares will reduce the proportional ownership percentage of existing shareholders by 5 percent. The immediate effect of this dilution is a decrease in share price. If the share price before the secondary offering was $30, the company had a market capitalization of $3 million (100,000 x $30) before the announcement. After the dilution, however, the $3 million market valuation must now be divided by the new total number of outstanding shares, 105,000, which drives down the value of each share to $28.57. The long-term effect of dilution on each shareholder’s proportional ownership is hard to predict at the outset.
What causes dilution?
- Holders of convertible preferred shares convert their stock options into common shares: Companies often offer stock options as part of their employees’ compensation package. These are commonly referred to as ESOs, which stands for Employee Stock Option. Conversion of these optionable securities increases the total share count which dilutes each shareholder’s proportional ownership percentage. Since the earning potential of each share is significantly reduced by a large number of conversions, it is important for investors to check the diluted earnings per share (EPS), which companies report in their financial statements. Diluted EPS represents the value of earnings per share if all optionable securities are converted to common shares.
- Issuance of secondary offerings: Public companies issue secondary offerings (additional shares) in order to raise more capital to grow the business or to reduce outstanding debt. They may also issue secondary offerings to prepare for an acquisition or expansion into international markets.
- Founders of a startup bring in new equity investors: While the basic process of dilution in this scenario is similar to the dilution resulting from a public company’s secondary offering, the implications and effect are distinguishable. A startup typically goes through several rounds of financing as it gets off the ground. The founders and initial investors’ shares will experience dilution with the addition of any new equity investors. Sometimes, the new investors are simply given a percentage ownership of the company. In other cases, the new investors are given a number of shares based on the value of the company and the value of the new investors’ contributions. In choosing how much of the “pie” to give to new investors, founders and initial investors must be careful to match the timing of financing rounds to growth milestones so they do not give away the shop. See “Selling Shares of Stock in Your Privately Held Corporation” for a discussion on selling shares in a small corporation.
How does dilution affect shareholders? Dilution carries a negative connotation for most investors. No one wants to see their stocks diluted. However, dilution is not always bad. In the case of dilution caused by a secondary offering, shareholders must determine whether the offering is made from a position of strength or weakness. The concept is similar to taking out a loan. In other words, they must evaluate whether the offering is being used as a building block to grow into a stronger, more successful company or as a warning that the heydays of the business are gone. Companies that are managed strategically are able to increase their earnings over time to offset the dilution that results from having a larger base of shareholders.
How can shareholders protect themselves from dilution? Shareholders can protect themselves from dilution from future rounds of financing or stock issuances through anti-dilution provisions, also referred to as preemptive rights or subscription rights, which usually appear in a corporation’s term sheet. These provisions give existing shareholders various rights, including preemptive rights to buy their pro rata share in a subsequent equity offering.
Whether you are an investor, drafting your business plan for a startup or thinking of bringing in new investors to your startup, it is best to consult with an experienced San Diego corporate attorney. For a free initial consultation, please contact us at (888) 900-9002.