5 Causes of Stock Dilution

Stock dilution affects shareholders by decreasing their ownership and voting power, often reducing earnings per share. In 2009, Citigroup’s conversion of preferred shares into common stock diluted existing shareholders and led to an 88% drop in stock price.

Similarly, Chesapeake Energy’s 2014 convertible debt offering contributed to a 42% stock price decline over the following two years, exacerbating existing financial woes.

5 Causes of Stock Dilution

Secondary Offering

The secondary offering is a common form of stock dilution that occurs whenever a firm issues additional shares of stock after the initial public offering. It is directly related to the existing shareholders to whom a firm issues fewer shares of stock.

For example, a company that has 100 million shares outstanding and issues an additional 50 million shares in a secondary offering to allow the new firm to raise money will lose one-third of its holdings.

Specifically, if a company has 20 million shares in flow, then the extent of the holding in the company after the secondary offering is reduced to 15 million shares. In other words, ownership falls by 5 million shares, or 25%, becomes diluted. Another example that help to understand the nature of secondary offering is Tesla’s 2020 offering. That year, the company announced a $5 billion secondary offering, which was the biggest in its history.

While it diluted its existing shareholders, the stock price rose during the year by 743%. The share price increased due to the belief in expansion plans and that the company’s business model was justified.

The main impact of the secondary offering is as follows:

  • Dilution of ownership: As new shares are issued and flood the market, the proportion of existing shareholders falls. This can be demonstrated in terms of the proportion of total ownership before and after the offering.

  • Price drop: As new issues multiplied, the price of shares fell in most cases. The reason was that fresh shares enhance supply and lower demand.

  • Capital raise: The funds and worth of capital enabling the stockbrokers to ultimately pass the rewards of secondary shares to companies.

According to historical data, secondary offerings have a beneficial effect on businesses in general. For instance, Goldman Sachs carried out the study and discovered that more than 70% of firms have made secondary offerings had share price increase of 15% on average during the next year. This idea is also captured by Warren Buffett in the following statement: “Be fearful when others are greedy, and be greedy when others are fearful.

Convertible Debt

Convertible debt is a financing instrument that combines features of debt and equity. Companies issue bonds or notes, which can be converted into a specific number of shares at the holder’s discretion. When bondholders exercise their option to convert the debt into equity, stock dilution occurs.

Example of 2016 Tesla Convertible Debt: In 2016, Tesla issued $1.38 billion of convertible bonds. The company announced the plan to use the capital to finance the production ramp-up of Model 3. Having a conversion price of $359.87 per share, the bonds above the company’s stock price was far from in the eyes of debt holders. As a result, driven by the parity of the fair values, they started to convert debt into equity, thus protecting the shareholders from dilution on paper but actually diluting many of the existing investors, but topping up the coffers of the company.

The following effects of convertible debt issuance may be outlined:

  • Increased Share Supply. As a result of bond conversion into shares in the case of Tesla, about 4.2 million new shares were offered, and thus diluted the ownership shares of the previous investors.
  • Interest Rate Reduction. The convertible debts are commonly featured with a much lower interest rate than the traditional bonds. However, the possible conversion option motivates debtholders to be interested in converting their debts into equity and benefiting from the higher share price. Thus, when Tesla issued the convertible bonds in 2016, they provided a 2.375% interest rate, which is hall less than the standard bonds’ interest rate.
  • High Capital Efficiency. The following fundraising strategy is often used by highly capital-efficient companies that finance their growth without raising cash. Investors agree to purchase the companies’ debts because they get an opportunity to convert these debts into equity when these stocks bring more value.

Some illustrative figures will prove that the above-mentioned debt-help strategy is effective. In our case concerning Tesla, 2016 allowed the company to transform from the niche producer of electric cars to one of the world’s biggest car manufacturers concerning capitalization.

Price is what you pay. Value is what you get… Those who understand convertible securities know this: It’s a double-edged sword. They know that they can get burned, and they accept that because they know sometimes they will get more gleam than noles.

Stock-Based Compensation

Stock-based compensation is an incentive mechanism employed by companies to provide their employees, including executives and board members, with ownership stakes through stock options, restricted stock units , or direct shares. Although stock-based compensation aligns their incentives with the company’s success, it can also lead to stock dilution. Every time employees exercise their options or RSUs settle, companies are “creating new shares of their stock and selling or giving them to their employees, thus decreasing existing shareholders’ ownership portion of the company”.

An example of a company adopting this compensation structure is Amazon, which consistently provides its employees and prospective talent with stock-related compensation to attract and retain the industry’s best minds in the technology segments and other competitive markets.

In 2022, the company’s stock-based compensation expenses were reported at $19.7 billion, recording a 15% annual increase in outstanding shares over the past five years. However, Amazon’s share price also tremendously increased during the same period because of the additional value brought to the business by these highly skilled employees.

The main effects of stock-based compensation are:

Share dilution: Existing shareholders’ stakes are inevitably reduced whenever new shares are created and employees are given stock options.

Incentivized workforce: Employees holding stock options or shares are directly affected by the company’s performance from a financial standpoint, spearheading a more incentivized and productive workforce, typically witnessing higher productivity and innovation.

Talent acquisition and retention: Competitive industries can benefit from attracting those with specialized talents, as stock-based compensation guarantees a future share of the company’s profits to the employees.

Potential overvaluation risks: If the company’s stocks become overvalued, it might lead to compensation overvaluation, increasing cost expenses and deflating profitability.

As Bill Gates put it in a business context, “your most unhappy customers are your greatest source of learning”. The concept is the same with stock-based compensations since broadening the incentive spectrum for employees to want the company to grow entails the risks of dilution. However, investors that truly understand value realize the immensely increased potential they can realize from attracting the best brains in the industry.

Warrants Exercise

Another key contributor to stock dilution is warrants exercise. Warrants are the right but not the obligation for holders to purchase a specific company’s stock at a predetermined price over a specific period. Simply put, when warrants are exercised, the companies need to issue new shares of stock that will be owned by warrant holders. Here are the key considerations: ways to exercise warrants and key impacts.

Example with Nikola Corporation

This electric truck startup agreed to issue warrants as part of a reverse merger with VectoIQ in 2020. The price of Nikola Corporation surged, reaching almost $80 per share. In these circumstances, warrant owners could purchase newly issued shares at the much lower price of $11.5 each. Overall, 28 million shares were sold, resulting in a 37 million-share dilution. As a result, the ownership percentage of previous stockholders was significantly diluted.

Key impacts of warrants exercise include:

  • Ownership percentage degree. Warrant exercise introduces new shares and reduces existing shareholders’ ownership percentages. The more shares owned compared to the total number of outstanding shares, the invested capitalists increase the power over the decision-making;

  • Cash infusion. Companies benefit when warrants are exercised, as exercise price markedly falls behind the buy market price of stocks, which results in immediate capital for the company. This money can be used for strategic purposes or the reduction of debt, for instance;

  • Unstable market conditions. The wires of a warrant exercising are likely to affect the market price if excess amount of warrants will be bought at the same time. The negative effect of market unrest will happen if the news of the announced dilution spreads quickly. Alternatively, the warrant exercising will be positively interpreted if the mentioned event might produce long-term results in a certain market;

  • Conditional dilution time. When stock prices in the market are higher than the warrant obligation price, it serves as a signal of future stock dilution not directly after warrants are exercised, but in the future.

As legend fund manager Peter Lynch once said, “Know what you own, and know why you own it.” Investors aware of the warrant exercising dilution potential can quickly distinguish momentous changes in the market and find new opportunities amid the dilution process.

Rights Offering

A rights offering is a type of stock dilution. The company issues new shares and gives existing shareholders the right to buy these shares at a discount. The procedure is intended to secure additional capital for the “mother” company while giving the “children” investors a chance to take the excess shares.

As an example, in May 2020, struggling South African energy major Sasol Limited announced a rights offering to raise $2 billion. Here, each shareholder was provided with a right to buy a new share to each one held. Sasol offered the shares at a substantial discount, and despite a stake dilution of 27% in convening the RS, most shareholders bought their super-discounted shares, thus helping the company stabilize its balance sheet. In this case, a dilution was unavoidable without an offering.

Short Summary

Rights offerings are utilized to raise capital while retaining shareholders’ interest. Overall, it preserves both the percentage of ownerships and percentage of control. Still, raising capital via RS will cause a dilution of out-of-pocket payment by those who do not subscribe for the rights. Although making a constant market price offer eliminated the urgently need of sorting out rights, in my opinion, the make-up period shifted too much with expected results deviating from the initial intentions. At least, the shareholders did not suffer the boom and bust of investment banking that is roughly 20%. Mainly, the procedure is significant when attempting to raise urgent capital.

Critical takeaways:

  • Rights offerings allow shareholders to retain the same percentage of ownership by being given a right to purchase shares.

  • New capital is raised, stabilizing the company’s financial status of the participants.

  • Shareholder who doesn’t participate in the rights offering will experience a dilution of its personal and organizational interest.

If you expect an offering to give a big premium, you’re trying to sell. The time to sell is never.” Would you take the offering? I believe that an investor needs to look past the 27% dilution and focus on whether there is a good reason to still buy the company’s post-RS equity.

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