- What - Dilution is the decrease in ownership of a company for existing shareholders that occurs when new shares are issued for that company.
- Value - In order for a shareholder to retain the value of their stake in the company, they would need to purchase new shares or need their new ownership of the company post-dilution to equal the same value pre-dilution.
- Diluted share price - A founder’s stake can gain value if the price of newly issued shares is sufficient enough to raise the diluted share price by a certain amount.
Dilution is the decrease in ownership of a company for existing shareholders that occurs when new shares are issued for that company (provided existing shareholders do not buy the new shares themselves).
To calculate the dilution of existing shareholder’s equity, the number of existing shares held by the shareholder needs to be divided by the sum of the total number of existing shares and the total number of new shares issued.
For example if a Fodsunder has an existing shareholding of 10,000 shares (S1) out of a total number of 35,000 shares (S2), their existing shareholding will be 28.57%.
If 20,000 new shares (S3) are issued, then the founder’s diluted shareholding (A) will be as follows;
S1 / (S2 + S3) = A
10,000 / (35,000 + 20,000) = 18.18%.
Provided that all of the new shares are issued and the founder does not buy any new shares themselves, the founder’s shareholding is diluted by 10.39%, from 28.57% to 18.18%
In order for the founder to retain the value of their stake in the company, they would either need to purchase new shares or would need their new ownership of the company post-dilution to equal the same value as it was pre-dilution.
For example, pre-dilution the founder’s ownership of the company was 28.57% and post-dilution it had fallen to 18.18%. If the company was worth $5 million, and remained so after the issuing of new shares, then the Founder’s stake would have been worth $1,428,500 pre-dilution (5,000,000 x 0.2857) and $909,000 post-dilution (5,000,000 x 0.1818).
For the founder to maintain the value of their stake following dilution, the company’s value after the issuing of new shares would need to rise so that the founder’s new ownership (18.18%) was equal to $1,428,500.
18.18% x company’s new value = 1428500.
A simple calculation shows that the company’s new value would, therefore, need to be at least $7,857,535.75 for the founder to maintain the pre-dilution value of their stake in the company.
7,857,535.7 is 1.57 times the original value of the company. Therefore, if the founder wanted to retain the value of their stake in the company and was confident that the company’s new value was at least 1.57 times that of its original value at the time of issuing new shares, or the issuing of new shares would increase its value by at least 1.57 times, then it would be sensible for them to issue new shares.
As you can see from the example above, dilution does not necessarily equate to a loss of value for existing shareholders.
Furthermore, a founder’s stake can gain value if the price of newly issued shares is sufficient enough to raise the diluted share price by a certain amount.
Let's again take the same example of a founder holding 10,000 shares (S1) out of a total 35,000 shares (S2).
The current price of existing shares is $50 (P1) and the 20,000 new shares (S3) are expected to be issued at $60 a share (P2). This would result in a new diluted share price of $53.64.
Diluted share price = (P1xS2 + P2xS3) / (S2+S3).
= (1,750,000 + 1,200,000) / (35,000 + 20,000)
= 2,950,000 / 55000
Pre-dilution, the founder’s stake in the company was worth $500,000 (10,000 x 50). Post-dilution their new stake in the company is worth $536,400 (10,000 x 53.64). Dilution, whilst reducing a shareholder’s ownership in a company, does not necessarily therefore equate to a reduction in the value of the stake of their ownership.
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