Equity dilution through the issuance of more shares could decrease the value of your stake in a company. If the company’s value doesn’t increase after the additional shares are issued, your holdings in it could be worth less because you would have a smaller ownership percentage. The new value of your stake would depend on how many shares are issued, their price and the terms.
Reasons for Dilution
A company may sell shares to raise capital for any number of reasons. If it is having trouble servicing current liabilities, it may sell shares to help cover expenses, particularly if covenants prohibit it from issuing new debt. Or, it may sell shares to fund acquisitions, expansion projects or other growth strategies.
Secondary Stock Offerings
Your ownership percentage of a company could decrease quickly if it issues new shares. If, for example, you own 1,000 shares of a company that has 100,000 shares and it sells another 100,000 shares, your ownership would be half of what it was previous to the issuance. Your 1,000 shares would be 0.5 percent of the company versus 1 percent before the offerings.
Issuance of Convertible Debt/Equity
A company may issue convertible debt that debt holders could convert into shares. Such convertible debt could dilute your equity by increasing the total shares held. Convertible debt is usually redeemable at a given ratio, like 100 shares of common stock for $1,000 of debt. Similarly, a company could issue convertible-preferred stock that would convert to a greater number of common shares, like 10 shares of common stock for each share of preferred stock.
Warrants, Rights and Options
Considering claims on security that could result in new shares when exercised could help you calculate equity dilution. A company may issue such claims, like warrants, rights and stock options, so that the holders may be more vested in the long-term growth of the business. But widespread exercising of options among employees, executives and stakeholders could significantly increase the pool of shares, thus diluting the value of your ownership.
Companies commonly disclose the existence of such claims in their annual filings. Leaders also may disclose when and how they would exercise options.
Dilution by Terms
Dilution usually occurs when new shares are issued, but the value of existing shares also could decline due to new equity terms. Issuance of preferred stock that prioritizes its shareholders should a liquidation occur could decrease the value of common stock by decreasing the likelihood of those investors being paid in such an event.
Calculating Equity Dilution
Shares don’t have to be issued to dilute your equity. Rather, the mere potential of stock being issued by means such as convertible debt or stock options makes your shares less valuable. Determining your ownership percentage on a fully diluted basis that accounts for all possible shares that could be issued will help you calculate equity dilution.
- Capshare: How Much is Your Equity Really Worth? The Difference Between Accounting Ownership and Economic Ownership
- Capshare: Dilution 101 – A Startup Guide to Equity Dilutioin with Real-World Statistics
- Founders Workbench: Ask the Capital Calculator: How Much Will I Be Diluted When I Take an Equity Investment?
- Equidam: Dilution 101: Calculation and Examples
- Investopedia: Dilution
- Just because your percentage has gone down doesn't mean the value of the shares has gone down. Continuing the example from the steps, say your 100 shares were worth $10,000, or $100 per share. If the new investor brings in an additional $12,500 of investment for his 125 new shares, your shares will still be worth $100 each.
Jim Molis has written about money management and financial services extensively during more than 20 years of experience as an editor and writer. He has been a staff writer for The Bond Buyer and a banking and finance reporter for the Atlanta Business Chronicle. He also has written for accountants and wealth advisors and has contributed to numerous publications as a freelancer.