What is dilution of shares?

When a company needs funds, it can issue new shares to the public to raise capital. This additional stock results in the dilution of existing shares. In other words, the percentage of ownership of the company conferred by each existing share goes down as new shares are issued. Companies do what is called a follow-on public offering (FPO) to raise more capital from the people.

This also affects the earnings per share(EPS) of a company. Dilution of shares results in a decrease in the EPS.

Dilution of shares cannot happen without the permission of the board of directors and shareholders. A special resolution is needed to be passed with the consent of at least 75% of the existing shareholders.

Reasons why a company looks for additional funds  

Paying off debt

Paying off debt can help a company become deleveraged and allocate more resources for other projects.

Buying new assets  

Buying new machinery or a new factory can help a company expand its business and operations.

Acquisitions 

A company may look to enter different industries through acquisition to diversify its business. It may also look to acquire a rival company to increase its market share. 

How dilution of shares work?

There are various ways through which a company can do stock dilution – 

Secondary offering or follow-on public offering (FPO)  

A company can collect capital from the public by issuing additional shares through FPO. This fund can be used for clearing debts, various expansion projects, or general corporate purposes.

Offering ownership against assets 

If a company is purchasing another business, it can offer its shares/ownership to its shareholders as compensation. This is called a share swap agreement. 

Conversion of stock option holders

Businesses also offer their shares in exchange for an individual's service. An employee stock option plan (ESOP) is a popular way for companies to dilute their ownership to give stock to employees. The stock options given to individuals or board members under various schemes can get converted into equity shares. 

Example of dilution of shares  

Let’s assume that a company has 100 shares trading at Rs 20 each. Thus, Rs 2,000 is the market capitalization of the company. Assume that it is divided equally among 5 investors. This means each investor holds 20 shares. 

This company now wants to expand, so it needs capital. So, it issues 100 more shares through an FPO. Assuming the stock price remains constant, this means that the company will raise Rs 2,000 more from the public.

This is where the dilution of shares happens. Before the follow-on issue, there were 100 shares total, so each share amounted to 1% ownership in the company. Now, there are 200 shares, so each share amounts to 0.5% ownership of the company. The five original investors, who owned 20% each of the company, now own only 10%.  

When an investor’s ownership gets diluted, his voting rights also get diluted. This is why most investors do not like the dilution of shares.

It is to be noted that this example has been exaggerated for ease of understanding, and the dilution of shares is not so sharp in the real world.

Benefits of dilution of shares

If you, as an investor, are only concerned with the percentage of your stake in the company and your voting rights, dilution may not be to your liking. But if you look at the long-term picture, additional funds gained from dilution may improve a company’s performance significantly, enhancing the value of your diluted stake much more than what it was before.

From the company's perspective, collecting more public funds may help expand the business, smoothly run business operations, reduce debt or even get out of a tricky financial position.

Other benefits of the dilution of shares 

Results in better revenue

If a company utilizes the capital collected from the public properly, it can generate better revenues for the company. For investors, this will result in better dividends and strong future growth in the stock.

Creates opportunity  

Sometimes, diluting shares results in a sharp decline in the price of the company's shares. If you are a long-term investor and trust the company, this may be a good chance for you to buy and increase your holdings at a lower price.

Reducing debt

The company may need additional funds to reduce its debt. Clearing up debt can give a boost to more fund allocation in the company's new projects, which can help in the expansion of the company.

Conclusion  

Share dilution happens when a company issues additional shares resulting in a reduction of the ownership in the company conferred by each existing share. Diluting shares may impact the stock price in the short term, but it could prove beneficial for all shareholders in the long run. 

The capital raised by share dilution can help the company reduce debt and fund expansion, and it could also be a means of tiding over a financial crisis. 

Share dilution can also happen through means of offering stock to employees and board members for their services or by funding an acquisition through share swap agreements.

FAQs

Q. What does dilution of shares mean?

The process of a company issuing new shares, which results in the reduction in the ownership in the company conferred by each existing share, is called share dilution. 

Q. How does the dilution of shares impact the existing shareholders?

When a company issues new shares, the ownership of the company conferred by each existing share gets diluted. Consequently, the percentage of ownership of the existing shareholders gets reduced. This also affects the earnings per share (EPS) of a stock.

Q. Is diluting shares a negative thing?

When a company dilutes its shares, it can negatively impact its stock price. But raising additional capital through stock dilution can help a company’s operations in many ways. If the business appreciates with the help of the new capital raise, it also helps the existing investors as they may get more dividends, and the stock price may go up in the long run.

Q. What is the difference between IPO and FPO?

When a company offers its shares to the public for the first time, it is called an Initial public offering (IPO). If an already listed company wants to raise more capital through the public issue of new shares thereafter, it is called a follow-on public offering (FPO). 

Q. Are shares diluted without the permission of existing shareholders?

A company cannot dilute its shares without the consent of at least 75% of the existing shareholders.