Dilutive issuances: Overview, definition, and example
What are dilutive issuances?
Dilutive issuances refer to the process of issuing additional shares or securities by a company, which results in a decrease in the ownership percentage of existing shareholders. This typically happens when a company issues new shares of stock, convertible securities, or options, which increases the total number of shares outstanding. As a result, the earnings per share (EPS) and voting power of existing shareholders may be diluted, meaning their proportional ownership in the company is reduced.
Dilutive issuances can occur for various reasons, such as raising capital, employee compensation, or making acquisitions.
Why are dilutive issuances important?
Dilutive issuances are important because they can affect the financial position of existing shareholders. While they can provide a company with necessary funding or resources, they also impact the value of existing shares. Understanding how dilutive issuances work is critical for investors, as it can affect the potential returns on their investment.
For businesses, dilutive issuances are an essential tool for raising capital or rewarding employees, but they must carefully consider the impact on existing shareholders and take steps to mitigate dilution if necessary.
Understanding dilutive issuances through an example
Imagine a startup company, Company A, is looking to raise capital to expand its operations. The company decides to issue 1 million new shares to new investors in exchange for $5 million in funding. Before the issuance, there are 10 million shares outstanding, and the existing shareholders own 100% of the company. After the issuance, the total number of shares outstanding increases to 11 million, meaning the existing shareholders' ownership percentage decreases from 100% to approximately 90.91%. This is an example of dilution due to the new issuance of shares.
In another scenario, an employee of Company A is granted stock options as part of their compensation package. If these options are exercised and new shares are issued, this would also dilute the ownership stake of existing shareholders.
Example of a dilutive issuance clause
Here’s how a dilutive issuance clause might appear in a shareholder agreement:
“In the event of any issuance of additional shares of stock or securities that are convertible into shares of stock (collectively, ‘New Issuances’) by the Company, the Parties acknowledge that such issuance may result in a dilution of the percentage ownership of the existing shareholders. The Company agrees to notify existing shareholders prior to any New Issuances, and such issuance shall not exceed [specified percentage] of the total shares outstanding without prior consent from the shareholders.”
Conclusion
Dilutive issuances are a key concept in corporate finance that can significantly impact the ownership structure of a company. While they provide a means for companies to raise capital, compensate employees, or make acquisitions, they also affect the ownership and value of existing shareholders’ stakes.
For business owners and managers, understanding dilutive issuances is essential for managing shareholder relations and ensuring that any new share issuances are balanced with the interests of current investors. For investors, being aware of the potential for dilution can help in assessing the future value and growth prospects of a company.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.