Stock Dilution: what is it and why does it matter?

The Complete Team
Stock Dilution: what is it and why does it matter?

What is Stock Dilution?

If a company increases the number of shares of stock available for purchase, the existing shares will be diluted. A company will do this with a follow-on offering. A company floats additional shares of its stock in order to sell those shares and raise more money. This money could be used to pay off debt, acquire new talent or companies, or invest in research and development. For these reasons, stock dilution is a common practice, especially among high growth companies.

What are stock classes?

Not all stocks are created equal. A company may create different types of stock, with some affording the shareholder certain rights and responsibilities.

Common Stock

Companies typically only have one type of common stock. But, in some cases, a company may want to create multiple types, or classes, with different levels of power. Remember, owning a stock is owning a piece of the company. This gives the shareholder power of the company’s direction. Different classes of stock carry different voting authority. One class, for example, may only be held by founders and senior executives, ensuring they retain control of the company, even as more shares are created. The specific rules around class designations of stock can differ greatly from company to company. For example, some classes may be publicly traded, while others may not be. As a general rule, an earlier letter in the alphabet indicates a more powerful stock class, so a Class A stock is more powerful than a Class B stock.

Preferred Stock

Preferred stock also affords shareholders ownership of a company, but does not afford them voting rights. Its major advantage over common stock is preference in receiving dividends, or a piece of the company’s profits. There are a few types of preferred stock:

  • Convertible Stock: preferred stock that can be converted into common stock at the option of the shareholder.
  • Participating Stock: stocks that pay higher dividends if the company outperforms its expected profits.
  • Cumulative Stock: if a company pauses dividend payments, cumulative stock ensures shareholders get dividend payments from the paused period after the pause is over.
  • Non-Cumulative Stock: stock that does not protect shareholders’ rights to dividend payments in the event of a dividend payment pause.

Effect on Shareholders

The effect of stock dilution on an individual investor’s asset value depends on how the valuation of the company changes. The company valuation is determined by a) how many new shares are being created and b) how much those shares are being sold for. This means the more money a company raises (e.g. additional funding rounds), the more diluted one’s ownership stake becomes.

With each new funding round, ownership share is decreased.

Here’s a simple example. A company has four shares, each valued at $2. You, as an investor, may hold one share, or 25% of the company. In order to raise money, the company floats an additional two shares of stock, also at $2 per share. The total valuation of the company, holding all else constant, raises from $8 to $12. You, as an investor, still hold one share which is still valued at $2. However, now your percent ownership of the company decreased from 25% to about 16%. In this way, your relative ownership of the company decreased, but your actual asset value stayed the same. With the additional $4 the company makes by selling the new shares, it can invest in hiring more talent to create new products. These products will create more value for the company, hopefully growing its valuation further. In this way, each individual shareholder traded off a bit of relative control of the company to allow the company to expand.

Share dilution does not necessarily leave this investor with more or less in asset value.

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