As per Section 2(84) of the Companies Act, 2013, the meaning of the term “Share” is “a share in the share capital of a company and includes Stock”. Shares are classified primarily into the following types:
Equity Shares – these represent ownership in a company and come with voting rights.
Preference Shares – these have preferential rights over equity shares regarding dividends and repayment of capital.
Share Dilution – Meaning
Every company has aspirations to grow and for that purpose, capital is needed. The source of this capital can be internally through retained earnings, or external funding can be sought through equity, debt, or hybrid instruments. When additional capital is raised by a Company by issuing equity, the percentage ownership of existing shareholders is reduced. Such a reduction is called a share dilution. Initially, a promoter starts a company with a 100% shareholding but later on when capital is raised or new shares are issued, that ownership stake gets reduced.
Thus, share dilution can be defined as the reduced or diluted ownership in a company’s stock for its preexisting shareholders when that company decides to issue fresh stock.
Share Dilution – Meaning, Reasons and Impact
Reasons for Share Dilution
Although the value of existing shares decreases when new shares are issued, companies still issue additional shares. Some of the reasons for share dilution are mentioned below:
Private Placement
A private placement is a method by which a company raises capital by issuing securities (such as shares or debentures) directly to a select group of investors, typically institutional investors, high net worth individuals, or strategic partners. When new shares are issued, which results in an increase in the total number of outstanding shares, the ownership percentage for existing shareholders is decreased, leading to Share dilution.
Initial Public Offerings (IPOs):
When a company sells shares to the public for the first time, it is known as an Initial Public Offering (IPO). The Company becomes publicly traded. Existing shareholders (founders and early investors) may experience dilution of their ownership percentage because the total number of shares increases but their shareholding remains the same.
Rights Issue
Rights Issue is a type of an invitation to the existing shareholders to buy additional shares of the company within the period specified. These are issued at a discounted price. If some of the shareholders do not take up the offer, they may experience dilution in their ownership percentage.
Employee Stock Options (ESOPs)
Employee Stock Option Plan is an employee benefit scheme through which employees own shares in the company. These shares are bought by employees at a price below the market price. When employees exercise these options, new shares are issued to them, increasing the total share count thus decreasing existing shareholders’ ownership percentage, leading to dilution.
Conversion of Convertible Securities:
Bonds or preference shares are usually convertible securities, which can be converted into equity shares at an agreed-upon price. This can lead to dilution when the holders choose to convert their securities into shares due to which the total share count increases, decreasing existing shareholders’ ownership percentage
Mergers and Acquisitions
Mergers as well as acquisitions are business transactions that combine two or more companies into a single entity. The purpose is to create a more efficient and effective company than the original two. Mergers as well as acquisitions can lead to share dilution for existing shareholders, primarily when new shares are issued to finance the transaction or in stock-for-stock deals. In such cases, the acquiring company may issue additional shares to exchange for the target company’s shares, increasing the total number of outstanding shares.
Debt-to-Equity Conversion
Debt-to-equity conversion (DEC) is a financial restructuring strategy where a company converts its debt into equity in exchange for the cancellation of its debt. This process is also known as a debt-equity swap. The process involves issuing new shares to creditors in exchange for forgiveness of debt. This results in share dilution because the issuance of additional shares increases the total number of outstanding shares, reducing the ownership percentage of existing shareholders.
Impact of Share Dilution on Business
Reduction in Ownership
Upon issuance of new shares, the ownership of the company is divided among an increased number of shareholders. This causes share dilution i.e., the percentage of ownership for existing shareholders gets reduced. The natural result is that the control and influence of the existing shareholders gets diluted over the decision making process of the Company.
Reduction Voting Power
Voting power gets reduced upon share dilution as the ownership stake and the ability to influence decisions within the company have a direct relation with each other. A larger ownership stake obviously grants more voting power. Thus, share dilution can impact promoters and initial investors, potentially decreasing their control over the company
Impact on Share Price
A dilution of shares could result in a drop in the price of the shares. There can be two reasons for the same which are (i) the value of each individual share decreases due to dilution and (ii) the announcement of share dilution, which is generally viewed negatively in the market. This is an indication to the market that a company may be in financial distress or looking for new capital. Negative sentiment among investors is created and by this perception. Share prices and the confidence of investors could be further impacted.
Earnings Impact
Company’s earnings were affected by share dilution resulting in a decrease in earnings per share (EPS). Due to the issuance of new shares, the total number of shareholders increases and more shares become outstanding. Now, if the company’s earnings do not increase proportionately, EPS will certainly decline.
Future Capital Raising
Companies may face problems in future fund raising efforts when shares of the company are diluted frequently. Repeated dilution can raise concerns about a company’s long-term strategy and financial health.
Employee Morale and Retention
Morale and retention of employees can be impacted by share dilution in a number of ways. When the equity ownership percentages of Employees get diluted, they may become less motivated or loyal to the company.
Strategic Decisions
There may be eventualities when the company may be required to take strategic decisions like acquisitions or capital investments etc. At that time, share dilution has to be considered, which will have a negative impact on the existing shareholders. As such, the Company is required to weigh the benefits against such potential negative impacts on shareholder value.
It is a fact that, for growth and stability, Share Dilution can sometimes be necessary. Therefore, it is absolutely essential for companies to communicate effectively with shareholders about the reasons for dilution and its anticipated benefits
Measures to Minimize the Impact of Share Dilution
Preemptive Rights
Preemptive rights are legal rights by which existing shareholders of a company are entitled to the option of buying new shares or ownership stakes before they are offered to outside parties. With this, the interests of existing shareholders are protected, which allows them to maintain their proportionate ownership in the company. This helps existing shareholders to take part in further rounds of funding without having their ownership stakes diluted. This approach helps in effectively reducing the impact of share dilution and existing shareholders’ investments and influence within the company are safeguarded. Preemptive rights preserve control and ownership structure, reducing the risks connected with share dilution, especially in organizations, which are venture-backed or startups or and family-owned businesses where maintaining ownership is crucial.
Strategic Financing
Share dilution can be effectively minimized by doing financing in a strategic way. Such strategic financing methods should be explored that do not require issuing new equity. Alternative funding sources are utilized so that the stakes of existing shareholders’ ownership are not compromised. Examples are bonds, bank loans or convertible debt. Companies are allowed to raise capital without immediately diluting existing shareholders’ equity. With debt financing, a company can borrow funds with fixed repayment terms, which avoids equity dilution. Further, revenue-based financing ties funding to revenue performance, which ensures that investors receive returns based on company performance rather than ownership stakes. Convertible debt can also be particularly useful as it defers dilution until a later date, providing companies with flexibility.
Careful Planning of Equity Issuance
When new shares are issued by a company, the ownership stakes of the existing shareholders are reduced. This results in share dilution. However, in case, careful planning of equity issuance is done, share dilution can be minimized. Before proceeding with new issuance, the timing and amount of new shares to be issued are to be determined in a strategic way.
Share Buyback
Through share buybacks, share dilution can be minimized. A company buys back its own shares from the market, which reduces the number of outstanding shares. The purchase of its own shares by a company increases the ownership stake of each investor and the value of the remaining shares. For this purpose, during the periods when a company has a strong cash flow or when the stock price of its share is undervalued, capital for share repurchase programs can be allocated and the total number of outstanding shares can be reduced. This not only can mitigate the effects of dilution from new share issuances but also can improve key financial metrics like earnings per share.
Employee Stock Options
Share dilution occurs when employees exercise their options, but there are strategies that can be adopted by companies to minimize this impact. Companies can use secondary shares to minimize share dilution when employees exercise their Employee Stock Options (ESOP). Secondary shares are existing shares that are acquired from the secondary market or non-promoter shareholders. When ESOP options are exercised by the employees, these shares are transferred to them. Thus, the creation of new shares is avoided. Other ways to minimize share dilution include (i) limiting the option pool, (ii) raising only what is needed, and (iii) refreshing stock options, which means granting more options to existing employees, which can keep them financially motivated to work with the company.
Optimize Capital Structure
The optimal capital structure is designed to maintain the perfect balance between maximizing the wealth and worth of the company and minimizing its cost of capital.. This can also help in minimizing share dilution. Companies need to regularly assess their capital structure, evaluating the cost of debt vis-a-vis equity and accordingly adjust their financing strategies. The need for issuing new shares is reduced by a well-optimized capital structure. This limits dilution and enhances financial stability.
How to Calculate Share Dilution
EXAMPLE
There is a company with the name Unique Pvt. Limited, which has 4,000 shares outstanding.
- Present Shareholders of the Company
- Ram has 1600 shares (which is 40% of the total shares)
- Shyam has 2,400 shares (which is 60% of total shares)
Unique Pvt. Limited needs funds for expansion and r decided to raise the same by way of issue of additional 2,000 shares to a new Investor with the name Mohan.
New Ownership Structure of Unique Pvt. Limited
- Total Shares after Issuance: 6,000 (4,000 existing + 2,000 new)
- Ram’s Ownership: Still 1,600 shares, now 1,600/6,000 = 26.67%
- Shyam’s Ownership: Still 2,400 shares, now 2,400/6,000 = 40%
Effect of Dilution
Ram’s ownership percentage has come down from 40% to 26.67%.
Shyam’s ownership percentage has decreased from 60% to 40%.
It can thus be observed that the issuance of new shares has diluted the ownership percentages of both Ram and Shyam even though they still own the same number of shares. This dilution has affected their voting power and the amount of profit they might receive per share in the future
Conclusion
Share dilution is the reduction in the ownership percentage of existing shareholders. It occurs when a company issues fresh stock. Understanding share dilution is vital for entrepreneurs, investors, as well as business leaders. The most common causes of share dilution include issue of new shares by way of Initial Public Offerings (IPOs): Rights Issues, Employee Stock Options (ESOPs)
Conversion of Convertible Securities and Mergers and Acquisitions etc. The impact can be positive or negative. However, negative effects can be reduced through rights offerings and strategic planning. Clear communication with investors is important. Accurate calculations help shareholders understand their stake. To know more alternate ways to financing your SME business contact us at BankKeeping.