Dilutive effect: Overview, definition, and example
What is the dilutive effect?
The dilutive effect refers to the reduction in the ownership percentage of existing shareholders when a company issues additional shares, such as in a new stock offering, employee stock options, or convertible securities. When a company raises capital by issuing more shares, the total number of outstanding shares increases, which can decrease the value or control of each existing share. The dilutive effect can impact shareholders in various ways, such as lowering their voting power or diluting their stake in the company’s profits.
For example, if a company with 1 million shares outstanding issues another 500,000 shares, existing shareholders will own a smaller percentage of the company post-issuance, resulting in dilution.
Why is the dilutive effect important?
The dilutive effect is important because it impacts the value and control that existing shareholders have in a company. While issuing new shares can help raise capital for business growth, it can also dilute the value of the shares already held by investors, leading to reduced earnings per share (EPS) or voting power. For investors, understanding the potential dilutive effect helps them assess the impact of future share issuances on their investments. For companies, managing dilution is crucial to maintaining shareholder confidence and ensuring that capital-raising activities do not significantly harm the value of existing shares.
For businesses, the dilutive effect can be a consideration when raising funds or issuing stock options to employees. For shareholders, understanding dilution helps assess the potential long-term value of their holdings.
Understanding the dilutive effect through an example
Imagine a startup company with 1,000,000 shares outstanding. The company decides to issue an additional 200,000 shares to raise capital for expansion. Before the new issuance, each shareholder owns a specific percentage of the company. However, after the new shares are issued, the total number of shares increases to 1,200,000, meaning that the ownership percentage of each shareholder is diluted. For instance, if an investor previously owned 10% of the company, their ownership percentage will now be reduced to approximately 8.33% after the dilution.
In another example, a company offers stock options to its employees. If employees exercise their options and the company issues new shares to fulfill those options, the existing shareholders’ ownership in the company will be diluted by the increase in total shares outstanding.
An example of a dilutive effect clause
Here’s how a dilutive effect clause might appear in a contract or shareholder agreement:
“In the event that the Company issues additional shares of stock, the Parties acknowledge that their ownership percentage may be subject to dilution. The Company agrees to provide advance notice to shareholders of any new share issuance that could result in a dilutive effect on existing holdings.”
Conclusion
The dilutive effect refers to the reduction in the ownership or value of existing shares when a company issues additional shares of stock. This can affect shareholders by reducing their percentage of ownership, voting power, or earnings per share. While issuing new shares is often necessary for raising capital, it is essential for both companies and investors to consider the dilutive effect and how it may influence the value and control of the business. Understanding dilution helps stakeholders make informed decisions about investing, participating in stock offerings, or managing their ownership stakes.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.