Stock dilution

Control dilution describes the reduction in ownership percentage or loss of a controlling share of an investment's stock. Many venture capital contracts contain an anti-dilution provision in favor of the original investors, to protect their equity investments. One way to raise new equity without diluting voting control is to give warrants to all the existing shareholders equally. They can choose to put more money in the company, or else lose ownership percentage. When employee options threaten to dilute the ownership of a control group, the company can use cash to buy back the shares issued.

The measurement of this percent dilution is made at a point in time. It will change as market values change and cannot be interpreted as a "measure of the impact of" dilutions.

1. Presume that all convertible securities are convertible at the date.
2. Add up the number of new shares that will be issued as a result.
3. Add up the proceeds that would be received on these conversions and issues (the reduction of debt is a 'proceed').
4. Divide the total proceeds by the current market price of the stock to determine the number of shares the proceeds can buyback.
5. Subtract the number bought-back from the new shares originally issued
6. Divide the net increase in shares by the starting # shares outstanding.

Earnings dilution describes the reduction in amount earned per share in an investment due to an increase in the total number of shares. The calculation of earnings dilutions derives from this same process as control dilution. The net increase in shares (steps 1–5) is determined at the beginning of the reporting period, and added to the beginning number of shares outstanding. The net income for the period is divided by this increased number of shares. Notice that the conversion rates are determined by market values at the beginning, not the period end. The returns to be realized on the reinvestment of the proceeds are not part of this calculation.

Value dilution describes the reduction in the current price of a stock due to the increase in the number of shares. This generally occurs when shares are issued in exchange for the purchase of a business, and incremental income from the new business must be at least the return on equity (ROE) of the old business. When the purchase price includes goodwill, this becomes a higher hurdle to clear.

The theoretical diluted price, i.e. the price after an increase in the number of shares, can be calculated as:

Theoretical Diluted Price = ${\displaystyle {\frac {O\times OP+N\times IP}{O+N}}}$

Where:

• O = original number of shares
• OP = Current share price
• N = number of new shares to be issued
• IP = issue price of new shares

For example, if there is a 3-for-10 issue, the current price is $0.50, the issue price $0.32, we have

• O = 10, OP = $0.50, N = 3, IP = $0.32, and
• TDP = (10 × 0.50 + 3 × 0.32) / (10 + 3) = $0.4585

Options and warrants are converted at pre-defined rates. As the stock price increases, their value increases dollar-for-dollar. If the stock is valued at a stable price-to-earnings ratio (P/E) it can be predicted that the options' rate of increase in value will be 20 times (when P/E=20) the rate of increase in earnings. The calculation of "what percentage share of future earnings increases goes to the holders of options instead of shareholders?" is[2]

(in-the-money options outstanding as % total) × (P/E ratio) = % future earnings accrue to option holders

For example, if the options outstanding equals 5% of the issued shares and the P/E=20, then 95% (= 5/105*20) of any increase in earnings goes, not to the shareholders, but to the options holders.

A share dilution scam happens when a company, typically traded in unregulated markets such as the OTC Bulletin Board and the Pink Sheets, repeatedly issues a massive number of shares into the market (using follow-on offerings) for no particular reason, considerably devaluing share prices until they become almost worthless, causing huge losses to shareholders.

Then, after share prices are at or near the minimum price a stock can trade and the share float has increased to an unsustainable level, those fraudulent companies tend to reverse split and continue repeating the same scheme.

Stock dilution has special relevance to investor-backed private companies and startups. Significantly dilutive events occur much more frequently for private companies than they do for public companies. These events happen because private companies frequently issue large amounts of new stock every time they raise money from investors.

Private company investors often acquire large ownership stakes (20–35%) and invest large sums of money as part of the venture capital process. To accommodate this, private companies must issue large amounts of stock to these investors. The issuance of stock to new investors creates significant dilution for founders and existing shareholders.

Company founders start with 100% ownership of their company but frequently have less than 35% ownership in the later-stages of their companies' life cycles (i.e., before a sale of the company or an IPO).[1] While founders and investors both understand this dilution, managing it and minimizing it can often be the difference between a successful outcome for founders and a failure. As such, dilutive terms are heavily negotiated in venture capital deals.

• Accretion/dilution analysis
• Diluted earnings per share
• Employee stock options
• Share capital