Dilution is a common risk that is usually part of the equation when someone becomes a shareholder with equity in a company, but it is seen negatively by shareholders. Learn what dilution is, how it affects stock prices, and what shareholders can do to protect against it.
What Is Dilution?
Imagine a company has issued 100 shares, and each share was purchased by an individual shareholder. Each shareholder expects to own 1% of the company. However, the company needs additional capital and decides to issue another 100 shares that are bought by another 100 shareholders. The original shareholders now only own 0.5% of the company, because their shares have been diluted and now they own a smaller percentage of the company. In other words, dilution happens when the shareholders’ equity positions are reduced as a result of new shares being created or issued.
Why Would a Company Choose to Dilute Its Shares?
There are many reasons why companies may choose to dilute their shares. The most common one is to raise additional capital to support operational growth and profitability, as it can be advantageous to have a larger investor pool for funding purposes. However, dilution is not always a positive sign.
A company may need to issue additional shares because the capital raised on their previous round has been exhausted. This may happen when a company needs increased capital to continue operating, but since ownership of a company is restricted to 100%, creating new shares allows for new investors to enter.
How Can a Shareholder Get Protection Against Dilution?
It is possible for an investor to protect themselves from dilution by including a dilution protection clause in their contractual agreement. This type of clause may limit how much an investor’s stake can be reduced should an additional funding round occur, or it can prevent their shares from being diluted altogether. It may also require discounted shares to be provided to that shareholder if the company decides to go ahead with a second funding round.
How Does Dilution Affect Stock Prices?
Dilution may affect stock prices because it reduces the company’s Earnings Per Share (EPS). Generally speaking, the degree of dilution of a company’s shares can greatly lower stock prices. Companies with fewer investors tend to have fewer issues with monetary losses or conflicts with large investors, as each investor is less likely to be affected by diminishing returns. If you are considering buying shares in a company or need to raise additional funding for your business, it is always recommended to seek the advice of a financial professional before proceeding. Call us today at 919-756-6437 to get the legal advice you need.