Updated July 14, 2023
Definition of Stock Dilution
Share dilution refers to the situation when the existing shareholders of the company losses 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.
Explanation
As per the word’s literal meaning, “dilute” means 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 occurs because the company increases the number or volume of its existing shares by the issue of new shares in the market. With the issue of new shares in the market, the ownership of the existing shareholders decreases. The company issues new shares in the market for various purposes, such as employee stock options and share issuance to investors, management, or other key individuals associated with 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 stock issue in the market. Various different factors cause the company to go for the dilution of stock. In many companies, when the employees perform exceptionally or well, the company gives them a reward in the form of company shares to appreciate their work or performance. When those employees exercise their option in the market, the number of shares issued by the company increases. Hence, the percentage ownership of the existing other shareholders is automatically 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 company shareholder owns 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 issued 100 shares at a price of $1000.Here the total number of the company’s issued share capital increases by $100,000, doubling the company’s issued share capital, i.e., $200,000.
% of holding of existing shareholders before new shares issue
| Particulars | Value |
| 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 shareholders after new shares issue
| Particulars | Value |
| 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 share dilution.
How to Stop Stock Dilution?
The following are some of the ways to stop Stock Dilution:
- There is a special right given to the company’s shareholders to have 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 to prevent a reduction of the percentage ownership in the company.
- No other right is given to any shareholder other than pre-exemption to avoid diluting the company’s stock.
- The company must specify the stock dilution limit in its articles of association or other legal documents.
Impact of Stock Dilution
The following are some of the impacts of stock dilution:
- There is a negative impact of stock dilution on the company’s shareholders. The shareholders hold because there is a reduction in the value of shares.
- Also, the number of issued capital of the company increases due to the new issue of shares in the market.
- The company’s future earnings get increased because the company keeps aside the money earned by the new issue of shares in the market, and these earnings can be used for any special purpose and any future project.
Dangers of Stock Dilution
There are some of the dangers of stock dilution:
- As there occurs a decrease in the ownership of the existing shareholding of the shareholders in the company, they lose the motivation to be there. Hence, when the company undertakes a new issue resulting in stock dilution, there is a risk of losing the existing shareholders.
- The new issue of shares by the company, which results in stock dilution of the company’s shareholders, is viewed as the company’s deteriorating financial health. Hence, it puts the wrong image in the eyes of the investors, along with many questions as to why the company suddenly went for the issue of new shares in the market. Also, the company losses its present investors too.
Conclusion
The company’s shareholders have no means to stop or prevent the company’s stock dilution except through pre-emption rights. However, a company can have different rights and regulations with regard to stock dilution. The articles of association and other legal documents of the company should specify the minimum and the maximum number of new shares that may issue in the future to safeguard the fundamental rights of the shareholders in the company and prevent any infringement upon those rights. The company’s shareholders should have all the knowledge and information of every new issue undertaken, along with the forms and ways of the new issue of shares.
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