Dilution
Dilution is the reduction of the existing shareholders' ownership interest in the company's stock at the time new shares are issued. When holders of stock options or other option securities exercise their options, this also results in stock dilution. When the number of shares on issue increases, then each share becomes less valuable. In other words, holders of stock have a smaller (diluted) share of the company.
A share is a security reflecting an ownership interest in the company's capital. An initial public offering (IPO) is one of the main ways a company goes public. For an IPO, the board of directors approves the number of shares to be issued ("float") for the initial offering beforehand. The number of offered shares increases when additional shares are issued ("secondary offering"), which leads to a decrease in the ownership interest of the shareholders in the company. In other words, the shares of the initial offering are diluted.
Understanding Dilution
Dilution is the division of a company and its stock into more parts. The larger the number of parts, the smaller the size of the parts themselves. That is, the owner of the shares will still get ownership, but the ownership part will be smaller than it was planned, which is undesirable.
Stock owners are the first to be affected by dilution. Also, dilution affects the company's earnings per share (EPS - net income divided by the number of shares outstanding), it decreases, and the stock price in the market decreases after that. Companies often publish undiluted and diluted earnings per share information to give investors a chance to evaluate opportunities if new shares are issued.
A company usually issues new shares when it wants to attract new investors and additional equity capital. In this way, the company sells additional shares and receives funds to improve the company's growth prospects and profitability, and thus increase the value of its shares.
Companies create share repurchase programs when they dilute shares in order to curb this effect and maintain positive relationships with existing shareholders. Share dilution does not equal share splitting. A stock splitting is the giving of additional shares with price adjustments to maintain a percentage interest of current investors in the company.
General example of Dilution
Imagine that the company presented 100 shares to 100 shareholders at the initial public offering. Each shareholder has 1% of the company's shares. Then, the company arranges a secondary offering of another 100 new shares to 100 new shareholders. In this case, each shareholder owns 0.5% of the company. The lower the investor's ownership percentage, the lower his or her voting rights.
Public companies often inform investors about their desire to issue new shares (dilution of current shares) ahead of time so that they can make plans.
Dilution Protection
Dilution devalues existing shareholder capital, so shareholders oppose it. There are clauses in contracts describing the providing of dilution protection in potential financing rounds. This makes it possible to limit or exclude the reduction of the investor's share interest in the company. This dilution protection (anti-dilution protection) extends to the shareholder in case of a decrease in his percentage of ownership of assets caused by the company's actions. Typically, any venture funding agreement contains a description of anti-dilution protections.
A company should always have a plan in case of an additional round of financing. If the company has a stock dilution plan, it should offer the investor a discount on the stock. This will allow to compensate for the dilution of the total ownership share, at least partially.
In the same way, an option or convertible security has an anti-dilution clause as part of the anti-dilution protection. It is the investor's protection against dilution due to subsequent issuances of shares at a lower price than the investor originally paid. Investors' favorite venture capital investment is convertible preferred stock, which often contains an anti-dilution clause description.
