A person who purchases shares of stock in a company has equity ownership in that company. The total number of shares outstanding that are available for trading is known as the “public float.” If the company decides to issue additional shares of stock in a secondary offering, the float increases and the value of shares held by the initial shareholders decreases. For example, electric carmaker Tesla has issued new shares of stock numerous times since its initial public offering (IPO) in 2010. Tesla’s capital-intensive projects have come at substantial costs, which the company funded in part by diluting shares. In December 2020, Tesla raised nearly $5 billion by issuing 2.65 million new shares. It was the third time that year the company issued new shares.
How Dilution of Shares Works
Companies issue additional shares of stock for a number of reasons, including:
Adding cash to the balance sheetRaising additional capital for growth opportunities, such as launching new products, building or expanding facilities, or expanding into new markets Acquiring another companyCovering employee stock options that were awardedPaying off debt
To better understand how dilution of shares works, consider this example: If company XYZ has a $1 million market capitalization and 100 investors each hold 100 shares of stock, then each shareholder owns 1% of the company, or $10,000. If the company issues another $1 million in shares, it would double its market capitalization to $2 million. The existing shareholders’ percentage of ownership then would be cut in half to 0.5%. In the tables below, we summarize this example.
Pros and Cons of Share Dilution
With dilution of shares, the value of the original shareholders’ stock remains the same (assuming the share price is unchanged), each shareholder’s percentage of ownership of the company is reduced.
Pros Explained
Can fund growth opportunities: A company may issue additional shares to fund projects or an acquisition that will help it increase revenue.Potential for larger dividends: Even though there are more shareholders receiving dividends, payouts may increase as a result of increased revenue, creating higher earnings per share.May help increase in share price over the long term: A company that uses funds generated by issuing additional shares could potentially create long-term growth that might lead to share price increases.
Cons Explained
Reduced ownership stake: Issuing additional shares will reduce existing shareholders’ percentages of ownership. Potential for smaller dividends: Because there are more shareholders to pay dividends to, if earnings per share do not rise to make up the difference, dividend payments may shrink. Potentially reduces earnings per share: Because there are more shares, the company will have to increase revenue or its EPS will decline. Reduced shareholder voting rights: Existing shareholders’ whose percentages of ownership drop will also experience a decline in voting rights.
What It Means for Investors
In most cases, shareholders can’t prevent dilution of shares. However, every shareholder has the right to sell their shares if they view a dilution of shares as a red flag for a particular company’s financial stability. Investors should understand the details provided by company executives as to why it is issuing new shares before they decide whether or not to remain invested.
