Equity Dilution-Let's Clear the Confusion

Equity Dilution-Let's Clear the Confusion

2021 was a year where every now and then, we heard of one or the other company coming out with an IPO, for example, Nykaa, Paytm, etc. But did we ever understand what it actually meant? Let's do it now.

What is equity dilution?

Raising money from the public in exchange for giving them a part of ownership is a vital decision on the company's part. It has to make sure of a number of things starting from: are funds actually required, if yes how much, how and where will these funds be utilized, would they be idle, what are the costs involved, what are we giving for getting these funds and what are the implications. And the last questions are of utmost importance because they directly affect the decision-making in the company and, if gone wrong, can have serious repercussions. There are various reasons as to why does it needs these funds. To cover expenses, fund working capital, growth and expansion, and numerous other reasons.

Whenever a company issues new shares to raise money from the general public, either for growth or expansion, it reduces the percentage of ownership of its existing equity shareholders due to an increase in the number of shares. This is known as equity dilution or stock dilution; with money flowing in as capital through these shares, the company's valuation increases. But with the increase in the number of shares and the shares being held by the existing shareholders remaining the same, it decreases the proportion of their shareholding.

For example, there are ten pens in which you are the owner of 5, and your friend is the owner of the rest of the five. Now another friend of yours brings his collection of 10 pens to this, making it 20. First, your percentage of ownership was 5/10, which is 50%, but now your percentage of ownership would be 5/20, which is 25%. It is really this easy.

Why does it happen?

A growing company can never stop with its growth and expansion programs, and these require money. Now, there are multiple ways to raise this money but issuing shares is not just a very viable option but the most widely used as well.

The first time it raises money and every other time it needs money, shares are issued, which dilute the equity.

Stock options like ESOP, which can also dilute equity, are widely used too because these are non-cash and lead to employee retention.

How does it happen?

  • There are multiple ways by which equity is diluted. An initial public offer(IPO), where a company issues shares to the public for the very first time, or secondary offerings where it raises additional capital through the issue of shares.
  • When the company employees exercise the right to stock options, the number of shares is increased. Whenever convertible bonds, debentures, and preference shares are converted into equity, that too increases the number of shares diluting the equity.
  • Bonus shares where even though no cash is raised, the number of shares is increased as a result of the capitalization of profits.
  • Whenever a company acquires another company, it issues shares as purchase consideration for the existing shareholders of the vendor company.

The effects of equity dilution

Equity dilution is not taken very positively by the company's existing shareholders, and they are not wrong because they are at the losing end facing everything that happens as an implication of equity dilution.

a)When the number of shares increases, it affects the ownership position in the company, i.e. control dilution because the share of the existing shareholders remains the same. Their voting power is also affected, and thus small stockholders can be violated. The company can either issue share warrants or buy back the shares to reduce this effect.

b)The earnings per share is also affected, i.e.earnings dilution. This is because Earnings per share are calculated by the formula Profit after-tax or equity earnings/No of shares. When the denominator is increased, the eps would obviously be a smaller amount. Thus, the existing shareholders lose a part of their own and a part of their earnings. This is why diluted EPS is calculated as well for decision-making by investors along with basic EPS. For diluted EPS, all the options that are convertible into shares at a later date are taken as converted into shares as of this date. The total amount of original and converted shares are taken as the denominator in the formula for EPS. Any savings that lead to an increase in profit, such as the debenture dividend, are also added to the numerator to have the fair final value.

c) The fall in EPS, in turn, reduces the market price of the stock. This is known as value dilution. The following formula can calculate the diluted price 

[(Original number of shares × current share price)+ (new shares ×share issue price)]/ total number of shares as of now(Original +new)

Conclusion

Whenever a company goes to raise funds through shares, it should consider the implications of dilution of equity and then move further with the plan if it looks feasible from the founders, investors, existing shareholders, and new shareholders market.

If you are looking for any Employee stock option plan (ESOP) services or consultants in Noida, Delhi, Gurgaon or anywhere in India, write to us at accounts@especia.co.in. Or Call On :(+91)-9711021268 +91-9310165114

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