Dilution
What is Share Dilution?
Every company aspires to grow and for growth, a company needs capital. This capital can be sourced internally through retained earnings, or the company can seek external funding through equity, debt, or hybrid instruments. When a company raises additional capital by issuing equity, the percentage ownership of existing shareholders is reduced. This is called share dilution. Dilution has no internal financial impact on a company, but it can be a point of contention for existing shareholders.
Key Learning Points
- Equity fundraising, stock compensation, mergers & acquisitions, and convertible bonds – any action that increases the number of outstanding shares – can cause dilution.
- Dilution can affect ownership, voting rights, and share prices, depending on the context.
- Anti-dilution clauses, debt, convertible debt, share repurchases, or the creation of unique equity classes can all be used to avoid dilution.
How Dilution Works
Assume the founder of a company owns 100% of the business through 100 shares. In need of capital, 100 new shares are sold to an investor. Now the founder’s share of the company has been reduced to 50%, since she owns 100 of the now 200 shares. This is an example of dilution.
Causes of Share
Share dilution can arise whenever companies issue additional shares. New shares can be issued by the following means:
Equity Fundraising
Companies can raise capital by selling shares. The capital raised might be used to fund capital expenditures or operational expense or provide an exit for existing investors.
For new or growing businesses, equity may be issues in stages. The earliest stage of startup funding is known as “pre-seed” and offers founders the capital to begin developing a product. In the “seed” stage, they raise more capital to fund growth and begin selling their product. As they grow, they may conduct “series” rounds in which they raise more capital to fund expansion. Once they’ve reached an optimal stage of growth, they will take the company public through an initial public offering (IPO), when shares are offer for sale through a public stock exchange. At each stage, an additional share issue dilutes the ownership of existing shareholders.
A public company may conduct a rights issue as follow on fundraising, offering existing shareholder the option to purchase additional shares at a discount to the market price. If a shareholder chooses not to exercise this option, their ownership will be diluted.
Example of Startup Dilution
Uber was founded in 2009 by Travis Kalanick and Garrett Camp, who initially owned most of the company’s stock. By the time Uber went public in 2019, their ownership had been diluted to single digits, with Garrett Camp owning 6.0% and Travis Kalanick owning 8.6%.
Source: Company filing, S1
Example of Fundraising via Rights Issue
On February 27, 2019, M&S, a UK-based retailer, announced a rights issue in which approximately 325 million new common shares were offered at a price of 185 pence per share in a 1 for 5 ratio. A qualifying shareholder who opted not to exercise their right or sold it experienced a 16.7% dilution [1/(1+5)] in their ownership.
Source: Company filing, issue prospectus
Stock-Based Compensation (SBC)
In addition to salary, many companies offer employees the opportunity to purchase stock. When management and employees own stock, it incentivizes them to act in the company’s best interest. Companies may offer stock options or give employees shares directly. Options or stock grants may be tied to company performance or be based on employee tenure. When the additional shares are issued, existing shareholders experience dilution.
Employee Stock Options (ESOPs)
ESOPs are granted to employees to purchase company shares at a designated exercise price, and typically vest over a 3–4-year period. At the time of vesting, if the exercise price is lower than the market price, an employee would buy the shares at the exercise price. Additional shares will be issued, diluting the positions of existing shareholders. If the exercise price is lower than the market price, the employee will not exercise the option.
For example, Ford’s stock options are currently in the money, meaning the exercise price is lower than the market price, as of Sep 22, 2023. If these options are exercised today, an additional ~1.29mm shares would be issued.
* We have used the treasury stock method to calculate the additional shares to be issued:
- If the current price is less than the exercise price, then no additional shares will be issued
- If the current price is more than the exercise price, then:
Source: Company filing, 10K, Dec 2022
Restricted Stock Units (RSUs) / Performance Stock Units (PSUs)
RSUs vest based on time. Once the vesting period is completed (usually a few years), the employee receives the shares or the cash equivalent. There are no specific performance conditions attached to RSUs. PSUs vest based on the achievement of predetermined performance goals or metrics set by the company, such as achieving certain financial targets, stock price targets, or other performance objectives. Unlike ESOPs, RSUs/PSUs are not options to purchase shares. Employees receive shares or money in their accounts upon vesting.
For example, Amazon has an outstanding balance of 481.5mm RSUs as of Sep 22, 2023. If these RSUs vested today, it would result in the issuance of an additional ~481.5mm shares.
Source: Company filing, 10Q, Jun 2023
Mergers and Acquisitions (M&A)
During a merger or an acquisition, when the acquiring company issues new shares to another company as a consideration, it dilutes the positions of existing shareholders.
For example, on February 19, 2014, Facebook announced its intention to buy WhatsApp for ~$16bn, using $4bn in cash and ~$12bn in Facebook shares. As part of the agreement, an additional $3bn in restricted stock was allocated to WhatsApp’s founders and staff, vesting over four years after the deal’s completion. As a result, WhatsApp shareholders and employees would have accounted for 7.9% of the newly combined company, reducing the ownership stakes of existing Facebook shareholders.
Source: Company filing, 10Q, Jun 2023
Convertible Bonds
Convertible bonds can be converted into common stock at a predetermined conversion price. If the conversion price is lower than the current stock price when the bonds mature (or earlier if the agreement allows it), the holder can exchange the bond for new stock instead of collecting the principal repayment. The issue of new shares is dilutive for existing shareholders. If the conversion price is higher than the market price, the holder will choose not to convert and receive the principal in cash at maturity.
For example, in 201, Tesla issued ~$2.1bn in convertible bonds in two tranches to finance the development and production of the “Gen III” mass-market vehicle, and construction of the Tesla Gigafactory. Tranche 1 of $920mm, due in 2019, didn’t result in conversion, and Tranche 2 of $1,200mm due in 2021, resulted in conversion.
Hence, investors with bonds maturing in 2019 gained little as the share price at maturity was far below the conversion price. Conversely, those with bonds maturing in 2021 were rewarded since the share price at conversion was 14x the conversion price. This substantial price surge led to the issuance of an additional 16.67 million shares.
Source: Company website Yahoo Finance for market data
Effect of Share Dilution
Share dilution can influence shareholder decisions in two ways
Impact on Ownership and Voting Rights
- Some investors are averse to any reduction in their ownership percentage, as it directly impacts their voting rights and could detrimentally affect their ability to secure a board seat and impact their influence over the company. As a result, they strive to avoid share dilution, prioritizing their ownership stakes
- For certain investors, it is important to maintain a particular stake. More than a stake 25% results in beneficial ownership while a stake greater than 50% gives the shareholder a controlling interest. These owners may play a significant role in the company’s direction and would not want their ownership diluted.
Effect on Share Price
Share dilution by itself doesn’t directly change the share price. However, when more shares are available, and if those shares are granted to employees or used in a merger, it can affect the share price in different ways:
- If many stock options or RSUs are granted, it will lead to an increase in diluted outstanding shares, which will lower the diluted earnings per share and can cause the share price to drop
- If a merger dilutes the combined company’s earnings per share, the share price may decline.
How to Prevent Share Dilution
Investors and companies use several strategies to protect their ownership stakes and mitigate the impact of dilution.
Anti-dilution clause
This is the most common clause in any startup’s fundraising agreement. It will adjust the price or number of shares owned based on the company’s valuation in subsequent funding rounds.,
This may be structured by issuing convertible preferred equity at the outset. Convertible preferred equity pays a specified dividend and can be converted into common stock at a fixed conversion ratio after a specified date or event. An anti-dilution clause helps to adjust the conversion or exercise price of convertible preferred equity, effectively protecting existing shareholders from dilution. The following are the most common types of anti-dilution strategies – Weighted Average Anti-Dilution and Full Ratchet Anti-Dilution.
In the case of Weighted Average Anti-Dilution, the conversion price for convertible preferred equity for existing shareholders is adjusted to the weighted average conversion price by considering all equity previously issued and currently being issued. Here, the existing convertible preferred shareholder receives compensation in the form of extra shares due to a lower conversion price. They are not fully protected from dilution, but the percentage ownership of the existing convertible preferred shareholder is protected from the sudden drop that would have been experienced without the clause.
In the case of Full Ratchet Anti-Dilution, the conversion price for convertible preferred equity for existing shareholders is adjusted to the lowest conversion price offered in the down-round. This clause restricts the share dilution for existing convertible preferred shareholders. In an extreme situation, this provision could result in founders losing control of their own company.
Illustration
Imagine Startup X raises $1million via convertible preferred equity from Investor A with a conversion price of $10 per share and grants 10% ownership to Investor A. Later, in a down round, the company needs to raise another $2 million via convertible preferred equity from Investor B with a revised conversion price of $5.
Without an anti-dilution clause, Investor A would have been left with 100,000 shares, resulting in a 7.1% stake in the company vs. His 10% prior to the down round.
However, with a Weighted Average Anti-Dilution clause in effect, the conversion price for Investor A would come down to $8.57 and the company would issue additional shares to Investor A. In comparison, this clause helped Investor A to maintain 8.2% ownership vs. 7.1% with no such clause following the down round.
With the Full Ratchet Anti-Dilution clause in effect, the conversion price for Investor A would come down to $5 and the company would issue more additional shares to Investor A at the lowest price at which new shares are issued. In comparison, this clause helps Investor A maintain a 13.3% stake vs. 7.1% without the clause.
Debt
Issuing debt to raise capital is an effective way to avoid dilution.
Issue Convertible Debt to Avoid Immediate Dilution
Convertible debt can be issued instead of common shares, giving bondholders the option to convert into stock at a later date. This prevents immediate dilution and gives the company time to grow and generate more value.
Create a special class of equity with non-reducing voting rights
Introducing a separate class of equity that retains a constant or non-reducing percentage of voting rights, even with the issuance of new shares, can help prevent dilution of voting power for existing shareholders. For example, Facebook’s Class B shares have 10 times the voting rights of regular Class A shares.
Stock Repurchase Program
If there has been dilution, a later share repurchase program could be implemented. This involves the company buying back some of its own stock from the market. This reduces the overall number of outstanding shares, which could increase the ownership percentage of the remaining shareholders.
Conclusion
Share dilution is a byproduct of a company’s growth when equity is issued for funding or acquisitions. It impacts ownership and voting rights. Anti-dilution clauses can help prevent dilution. Companies can also minimize dilution by utilizing debt, retained earnings, or alternative instruments like convertible debt.