Stock Dilution: What it is, How it Works and Examples

Key Points

• Stock dilution can lower the value of existing shares and reduce a shareholder's ownership percentage in a company.
• Stock dilution happens for various reasons, such as raising capital, retaining talent and reducing debt.
• Investors should closely monitor stock dilution, as it can impact the value of their investments and voting rights.

Investors and traders need to understand stock dilution because it can lower the value of existing shares and reduce a shareholder's ownership percentage in a company. If that sounds confusing, don't worry. 

What is diluted stock? Understanding what diluted shares mean is crucial for investors, as it directly influences the company's equity structure and financial prospects. In doing so, you'll arm yourself with powerful knowledge that may set you apart from other market participants when making informed investment decisions. 

What is Stock Dilution?

What is dilution in stocks, exactly, and what are diluted shares? To better explain this concept, let's start with an example. 

If you decide to purchase company shares, you are considered a part-owner of that company. Suppose that company decides to introduce new shares to the public. In that case, your ownership percentage will decrease or be diluted due to the influx of additional shares to the public. 

For example, if you own 10 shares of a company that has 10,000 shares outstanding, you will own 0.1% of the company (10 divided by 10,000). If the company decides to issue an additional 5,000 shares, your ownership will decrease from 0.1% to 0.066% (10 divided by 15,000). 

So, share dilution reduces the ownership percentage of existing shareholders in a company by issuing additional shares for public sale, thereby increasing the public float. This influx of new shares, often achieved through secondary offerings, allows companies to raise capital for growth, expansion or debt settlement. However, as shown above, it can also lead to a decrease in the value of existing shares and a potential loss of control for current shareholders. 

How Stock Dilution Occurs

Shareholder dilution occurs when a company decides to increase the number of its outstanding shares, leading to a decrease in the ownership percentage of existing shareholders. Various events can cause equity dilution. For example, a company might offer additional shares of common stock through secondary offerings or private placements. Diluting shares can also occur due to the issuance or conversion of preferred shares or warrants into stock. Another common way for shareholder dilution to occur is when employee-restricted stock vests.

Types of Stock Dilution

Let's take a look at a few types of stock dilution to help expound on the share diluted meaning, including the answers to questions like, "Do employee stock options dilute?"

Restricted Stock

Employees of publicly traded companies might be awarded restricted stock as part of their compensation package. Restricted stock units (RSU) represent a specific number of shares an employer has promised an employee on a future date. When the shares vest on a future date, they become available to the employee, and the employee then owns the shares and becomes a part owner of the company. As a result of the issuance of equity, other company shareholders are diluted as the total amount of outstanding shares has now increased. 

Convertible Preferred Shares

Common stock represents ownership in a company with voting rights. However, preferred stock typically represents stock that offers fixed dividends but lacks voting rights. Convertible preferred stock allows investors to convert preferred stock into common stock at their discretion. As a result, preferred stock can dilute shares if it is convertible. When convertible preferred stockholders exercise their conversion rights, additional common shares are issued, which can reduce the ownership percentage of existing common shareholders.

Warrants

Warrants are financial instruments that give the holder the right to purchase a specific number of shares of a company's common stock at a predetermined price within a particular period. Warrants can dilute shareholders because when they are exercised, new shares are issued to the warrant holders at the predetermined price. The issuance of new shares increases the total number of outstanding shares, reducing the ownership percentage and potentially the value of existing shares for other shareholders. 

Convertible Debt

Convertible debt, often issued as bonds, offers investors fixed interest payments and a predetermined maturity date. Convertible debt also allows investors to convert their debt into a predetermined number of shares of the company's common stock. If a bondholder exercises this conversion option, new shares are issued, increasing the total number of outstanding shares, leading to share dilution. 

Companies may opt for convertible debt as it allows them to raise capital at a lower interest rate, making it an attractive option for both the company and investors, as the investor can convert the debt into equity. 

Why Does Stock Dilution Happen?

Stock dilution takes place for several reasons, and it is a common occurrence in the financial world. The most popular reason for shareholder dilution is for the company to raise capital for expansion and growth. Let's go over the primary reasons for shareholder dilution.

Raise Capital 

Companies will issue new shares, and dilute shareholders, to raise additional funds for several purposes. For example, a company might raise capital to expand operations, invest in new projects, or fund acquisitions. Often, penny stocks, biotech stocks and mid-cap stocks will raise capital more frequently than blue-chip stocks due to a lack of profitability and limited access to traditional financing or for growth and expansion. A company can raise capital by selling additional shares to the public without taking on new debt or additional liabilities. 

Retain Talent 

To retain and attract top talent, publicly listed companies often offer stock-based compensation, like restricted stock units and stock options. Of course, once employees receive their vested stock or exercise their stock options, additional shares are issued, resulting in stock dilution. In particular, large-cap stocks, with their established positions and higher market valuations, have the financial resources to implement such programs. 

Make Strategic Investments

Companies will use dilution stock tactics to attract specific investors who can add valuable expertise and industry knowledge, aiding the company's growth and expansion efforts. Innovative companies in the technology sector frequently issue common stock to fund their expansion and research development efforts.

Reduce Debt

A company might issue new shares to raise capital to reduce debt and improve its financial health. For example, a company may use the proceeds from the issuance of shares to pay off debts or restructure its financial position, resulting in lower interest payments and debt obligations. It's common practice for utility companies to raise capital to reduce or manage debt due to the high infrastructure costs required to deliver essential services. 

How Stock Dilution Impacts Investors

Investors should closely monitor a company's need for raising capital and stock dilution, as it can impact the value of their investments. The issuance of new shares will reduce the value and ownership percentage of existing shares, as outlined in detail above, potentially impacting voting rights in significant company decisions. Stock dilution can also influence a company's earnings per share (EPS), with an increase in its outstanding shares causing a decrease in its EPS, for example. 

How to Calculate Stock Dilution

You must know the total number of outstanding shares before and after the dilutive event to calculate the stock dilution, which you can total them by hand or use a stock dilution calculator. 

For example, if a company had 10,000 outstanding shares and issued an additional 5,000 shares through a secondary offering, the stock dilution would equal: 

(New Shares Issued / (Existing Shares + New Shares Issued)) x 100 

Therefore, (5,000 / (10,000 + 5,000)) x 100 = 33.33%. 

This means that the stock dilution resulted in a 33.33% decrease in the ownership of existing shareholders. 

So what impact would the stock dilution have on your ownership if you owned 100 shares? Before the offering, you owned 1% of the company (100 shares / 10,000 outstanding shares). However, after the offering, you would own 33.33% less (100 shares / 15,000 shares outstanding), or 0.66%, according to your own math or a dilution stock calculator. 

Example of Stock Dilution

On July 14, a clinical-stage pharmaceutical penny stock, PainReform (NASDAQ: PRFX), announced a $1.5 million concurrent registered direct offering and private placement pricing. 

According to the press release, PainReform entered an agreement to purchase and sell 166,666 of the company's ordinary shares (or pre-funded warrants), at a purchase price of $9 per ordinary share, in a registered direct offering. The company agreed to issue in the offering unregistered warrants to purchase up to an aggregate of 166,666 ordinary shares.

This offering dilutes existing shareholders since the offering will introduce 166,666 new shares by purchasing ordinary shares and unregistered warrants. The total number of outstanding shares will increase. Before the offering, PRFX had 1,060,000 shares outstanding. After the offering, the company will add 166,666 new shares. Therefore, the total outstanding shares after the offering will be 1,060,000 + 166,666 = 1,226,666. The stock dilution therefore equals = (166,666 / (1,060,000 + 166,666)) x 100 = 13.5%.

The offering will result in a 13.5% dilution in the ownership percentage of existing shareholders.

Know and Understand Stock Dilution

Now that we've answered the question, "What is a diluted share?" and as you now know, stock dilution can significantly impact the value of an investment by diminishing share value, ownership percentage, and even voting power. However, even though dilution occurs as companies raise capital through new share issuance, it can also lead to higher returns. 

So while there might be short-term impacts to the investor, the stock dilution could yield benefits and advantages, as the company could expand or improve its financial position through the offering. 

Understanding different dilution forms and their impact on EPS is crucial for making well-informed investment decisions. By vigilantly monitoring a company's capital requirements and historical stock dilution, you can gauge its potential impact on the value of your investment and make prudent choices.

FAQs

Let's go beyond "What does diluting shares mean?" and answer a few more questions about the stock dilution meaning.

Is dilution good for stocks?

In the general dilution stocks meaning, stock dilution is generally not considered good for stocks because it dilutes existing shareholders. When a company issues new shares, thereby diluting its stock, it decreases the ownership percentage of existing shareholders.

What does stock dilution mean?

What are dilutive shares? Diluting stock involves reducing the ownership percentage of existing shareholders in a company by issuing additional shares for public sale, thereby increasing the public float. 

Is stock dilution legal?

Yes, stock dilution is legal. Companies often use diluting shares to raise capital for several reasons, including growth and reducing debt.

Do stock splits dilute shares?

No, stock splits do not dilute shares. In a stock split, the company will increase the number of outstanding shares by splitting the existing share into multiple new shares. Shares will not be diluted as the overall value of the investment will remain the same.