Dilutive vs. Anti-Dilutive: An Overview
Publicly traded companies can offer either dilutive or anti-dilutive securities. These terms commonly refer to the potential impact of any securities on the stock's earnings per share. The fundamental concern of existing shareholding after new securities are issued, or after securities are converted, is that their ownership interests are diminished as a result.
It isn't just shareholders who are concerned about dilution of EPS through the exercising of securities. Both accountants and financial analysts compute diluted earnings per share as a worst-case scenario when evaluating a company's stock.
- When a company issues new equity stock, it increases the number of shares outstanding, making the number of shares already owned represent a smaller percentage of overall ownership.
- Shareholders typically resist dilution as it devalues their existing equity stake and reduces a firm's earnings per share.
- Anti-dilutive securities such as convertible notes, or clauses that protect shareholders from dilution, include mechanisms that keep the overall number of shares outstanding the same.
Dilutive securities are not common stocks initially. Rather, most dilutive securities provide a mechanism through which the owner of the security can obtain additional common stock. This mechanism can be either an option or conversion. If triggering the mechanism results in a decreased EPS for existing shareholders—by increasing the total amount of outstanding shares—then the instrument is said to be a dilutive security.
Some examples of dilutive securities include convertible preferred stock, convertible debt instruments, warrants, and stock options.
Not all security mechanisms result in decreased EPS, and some even increase EPS. If securities are retired, converted or affected through certain corporate activities, and the transaction results in an increased EPS, then the action is considered to be anti-dilutive.
Some security instruments have provisions or ownership rights that allow the owners to purchase additional shares when another security mechanism would otherwise dilute their ownership interests. These are often called anti-dilution provisions.
Though not a security, the word "antidilution" is sometimes applied to acquisitions of one company by another through the issuing common stock, when the value-added through the acquisition offsets the new shares such that total EPS is increased.
Shareholders typically resist dilution as it devalues their existing equity. Dilution protection refers to contractual provisions that limit or outright prevent an investor's stake in a company from being reduced in later funding rounds. The dilution protection feature kicks in if the actions of the company will decrease the investor's percentage claim on assets of the company.
For example, if an investor's stake is 20%, and the company is going to hold an additional funding round, the company must offer discounted shares to the investor to at least partially make up for the dilution of the overall ownership stake. Dilution protection provisions are generally found in venture capital funding agreements. Dilution protection is sometimes referred to as "anti-dilution protection."
Similarly, an anti-dilution provision is a provision in an option or a convertible security, and it is also known as an "anti-dilution clause." It protects an investor from equity dilution resulting from later issues of stock at a lower price than the investor originally paid. These are common with convertible preferred stock, which is a favored form of venture capital investment.