Definition: The lessening of ownership that a corporation’s shareholders suffer when it issues new shares to new shareholders.
Example: DLT Corporation has 1,000,000 shares outstanding. Devin owns 10,000 of those shares. Because of difficult economic times, DLT is having trouble repaying money it previously borrowed. It decides to issue 100,000 new shares and use the cash it collects to pay off its debts. Devin used to own 10,000/1,000,000, or 1/100th of the company. After the share issuance, Devin will own 10,000/1,100,000, or 1/110th of the company. His ownership will be diluted.
Investeach explains: With more shares over which to spread a company’s profits, the market price of the shares of a company issuing new shares often falls to reflect the dilution that is occurring.
There is no real limit on the number of new shares a company can issue. What keeps companies from issuing new shares for cash is its current group of shareholders. New shares water down the ownership of the current shareholders. Therefore, companies rarely issue new shares and when they do, its for a good reason. An example is to obtain more cash to buy out a competitor. Another sound reason was mentioned in our example. If a company has its back up against the wall and can’t pay its debts, it may be better to have its shareholders suffer dilution than have the company go bankrupt. If it did go bankrupt, the shares could be worthless.
Finally, companies can reverse the effect of prior dilution by purchasing shares back from the public. These shares, known as Treasury Stock when held by the company, are considered to be out of circulation. They lose the rights they had when they were active, ensuring we don’t consider the company to be owning itself by purchasing its own shares.
Riddle me this:
1. Who suffers dilution?
2. What is the upper limit on the number of shares a company can have outstanding?
3. Why might a company dilute its shareholders?
4. What can a company do to reverse the effect of dilution?