What is Share Dilution?
The phenomenon of printing stocks by the company, which reduces the RELATIVE size of the asset held by existing shareholders is called – DILUTION.
It dilutes, takes away the potency and power, of each and every pre-existing stock.
To understand this let’s look at an example:
Joe and Oliver decided to set up a software company called Joliver Ltd, and together they invested $100,000 in the business venture.
The company issued 100,000 shares of $1 each.
In exchange for the investment, each founder received 50,000 shares to reflect the capital invested.
These stocks reflect the rights and are composed of:
- The right to receive their share of any profit distribution,
- In the case of dissolution, they will have the right to receive their share of any leftover assets, after the company’s liabilities are settled.
- A right to participate and represent their share of the business in determining the actions of the company.
Joe and Oliver decided they would like to buy a competitor, Danny’s Codes Ltd, which costs – $200,000. Joliver Ltd has only $100,000 available.
What will they do? Zoe, Joe’s aunt, comes up with an idea: she will invest the additional $100,000 in Joliver Ltd to become one of the owners of the company.
Joe and Oliver agree. Success!
The company issues another 100,000 shares of $1 each and exchanges them with Zoe for the funds and promptly buys Danny’s Codes Ltd.
Let’s study what happened to Joe’s and Oliver’s holdings.
Initially, Joe and Oliver held 50,000 shares each from 100,000 shares issued to shareholders. The total number of shares issued is called Shares Outstanding. These are shares the company made and sold to investors for money or some other exchange.
We can say that Joe and Oliver each controlled 50% of the total shares outstanding of Joliver Ltd. Neither Joe nor Oliver had any power to have a majority of votes of the outstanding shares to pass a resolution regarding the fate of the business.
Let’s see what happened after Zoe joined them.
Both still control the same 50,000 stocks, but now they are a smaller part of the whole outstanding shares that grew to 200,000 shares outstanding.
Joe controls 50,000/200,000 = 25%
Oliver controls a similar stake = 25%.
Zoe controls 100,000/200,000 = 50% of the company.
Joe’s and Oliver’s RELATIVE part in the company just shrank.
And with respect to control, now just Zoe with one of the shareholders’ support could decide what the company does when 51% majority is needed, even if the other original owner disagrees and votes against the proposal.
Printing more shares means nothing for the clients and managers of the Joliver Ltd. It’s still the same company delivering the same products or services.
It is another thing altogether for the shareholders, of course.
That is not bad $50,000/$200,000 = 25% return, per annum, on their capital investment.
Let’s pretend Danny’s Codes Ltd. brought in an additional $200,000 per year, and earns, under Joliver employees and cost basis, an additional $60,000 in profits.
That’s even better since $60,000/$200,000 = 30% annual return on the new capital.
The New Joliver Ltd is not only a larger firm that is stronger, but it is also more profitable.
Before the dilution, Oliver and Joe each controlled $25,000 worth of profits.
It is an unfortunate observation that managers are much more likely to mess up the use of dilution, as we will cover in another video.