Stock dilution occurs when a company's action increases the number of outstanding shares and therefore reduces the ownership percentage of existing shareholders. Although it is relatively common for distressed companies to dilute shares, the process has negative implications for a simple reason: A company's shareholders are its owners, and anything that decreases an investor's level of ownership also decreases the value of the investor's holdings.

Dilution can happen in any number of ways and announcements of company actions that dilute shares are typically made during investor calls or in a new prospectus. When it happens, and the numbers of company shares increases, the newer shares are the "dilutive stock."

Secondary Offerings

If a company has a total of 1,000 shares of float on the market, for example, and its management issues another 1,000 shares in a secondary offering, there are now 2,000 shares outstanding. The owners of the first 1,000 shares would face a 50% dilution factor. This means that an owner of 100 shares now owns 5% of the company rather than 10%.

Key Takeaways

  • Dilution occurs when a corporate action, like a secondary offering, increases the number of shares outstanding.
  • Exercising stock options is dilutive to shareholders when it results in an increase in the number of shares outstanding.
  • Dilution decreases each shareholder's stake in the company but is often necessary when a company requires new capital for operations.
  • Convertible debt and equity can be dilutive when these securities are converted to shares.

Dilution does not necessarily mean the dollar amount of the investment changes, but since the shares held are a smaller percentage of the total company, the investor has less pull in the company's decisions and their stake represents a decreased percentage of the company's overall earnings.

Although news of a secondary offering is typically not welcomed by shareholders because of dilution, an offering can inject the company with the capital necessary to restructure, pay down debt, or invest in research and development. In the end, acquiring capital through a secondary offering can be a longer-term positive for the investor, if the company becomes more profitable and the stock price rises.

Exercising Options

When exercised, certain derivatives instruments are exchanged for shares of stock that are issued by the company to its employees. These employee stock options are often granted instead of cash or stock bonuses and act as incentives. When the option contracts are exercised, the options are converted to shares and the employee can then sell the shares in the market, thereby diluting the number of company shares outstanding. The employee stock option is the most common way to dilute shares via derivatives, but warrants, rights, and convertible debt and equity are sometimes dilutive as well.

Convertible Debt and Convertible Equity

When a company issues convertible debt, it means that debt holders who choose to convert their securities into shares will dilute current shareholders' ownership. In many cases, convertible debt converts to common stock at some preferential conversion ratio. For example, each $1,000 of convertible debt may convert to 100 shares of common stock, thus decreasing current stockholders' total ownership.

Convertible equity is often called convertible preferred stock and usually converts to common stock on a preferential ratio. For example, each convertible preferred stock may convert to 10 shares of common stock, thus also diluting ownership of existing shareholders. The effect on the investor who held common shares prior to the dilution is the same as a secondary offering, as their percentage of ownership in the company decreases when the new shares are brought to market.