Personal Finance & Money Stack Exchange is a question and answer site for people who want to be financially literate. Join them; it only takes a minute:

Sign up
Here's how it works:
  1. Anybody can ask a question
  2. Anybody can answer
  3. The best answers are voted up and rise to the top

What I always heard, since I was a child, was that if you own a stock share, you actually own a small share of a company. That seems to be the general consensus of what a stock share is.

Well, that said, let's assume I have 10 out of 100 shares of a company. If that company issues another 100 shares, shouldn't 10 of those new 100 shares be mine? Apparently it is not, and my ownership of the company is halved. How can they take 5% of the company from me without paying its due value? Shouldn't it be illegal?

I am certain I have some misconceptions on how these things work. How is it really done?

share|improve this question
    
money.stackexchange.com/questions/10904/… would be a related question to this as usually there are rules about how the company was formed that determine things is what you are missing here. – JB King Jan 22 at 17:34
15  
"If that company issues another 100 shares, shouldn't 10 of those new 100 shares be mine?" this scenario is a stock split – user662852 Jan 22 at 17:50
3  
Mostly in those case, increase of authorised share capital or rights issues , companies contact their existing share holders to offer them more shares. They willn't give it to you for free. They are doing it to generate money to invest in the business. – DumbCoder Jan 22 at 18:24
3  
Notice that the opposite is also possible. A company can use its excess money to buy back its own shares. Therefore the total shares of the company decrease, and the percentage of ownership of every shareholder increases. – Zenadix Jan 24 at 0:02
1  
I have wondered the same too, except in the context of inflation and why it's legal for the government to continue to churn out money. – Vandermonde Jan 24 at 17:58
up vote 31 down vote accepted

Here's another way that I look at it:

Say you and me were 50-50 partners in a small business. Suppose we wanted to expand our business but that needed money. Someone (let's call him Warren) has the money we need & hence in return for the money we offer Warren an equal stake in the business.

i.e. All three of us own 33% stake now. For both you and me our stake reduced from 50% that it was before Warren's entry to only 33% now.

While that reduction in our share may seem at first sight a bad deal for us, we both agreed to give Warren his share consciously not out of altruism but because it made business sense to helps us expand.

Ergo, what matters is not just your share of the pie but the size of the pie itself! And hence dilution of stake can make sense under certain circumstances.

Two small points:

(a) This doesn't in any way show the dilution must make sense. Only that it can sometimes make sense

(b) Of course, in the case of a large corporation they do not need your personal approval for the dilution. But hey, neither do they ask you when they buy a new plant or start a new product.

share|improve this answer
    
All answers helped me create the mental model to understand (and accept) how this works. But I am accepting this one because it seems to be the most simple way to convey the idea, and this is how I will explain it myself if I am ever asked about it. – lvella Jan 25 at 17:17
3  
It might be easier to think of it if you put numbers on it. Curious Cat and lvella each own 50% of Acme Products, a company worth $100. So each one has $50 in equity. Now Warren comes along and invest $50, so you give him 1/3 of the company. Cat and Ivella have been diluted down to 1/3 as well, but now Acme Product is worth what it was before plus the $50 it got from Warren, so $150, and the original investors' equity is still worth $50! Of course, the company might be worth more (because it's better capitalized) or less (because there are more chefs in the kitchen). – Malvolio Jan 26 at 1:27
    
Thanks! That was my very first post on Money.StackExchange :) Glad I could help. – curious_cat Jan 26 at 2:42
    
Do curious_cat and Ivella have to equally put up the shares for Warren? Could curious_cat keep 50%, shrink Ivella's shares to 25% and give Warren 25% without permission? – Prinsig Jan 26 at 12:29

Theoretically, when a company issues more shares, it does not affect the value of your shares. The reason is that when a company issues and sells more shares, the proceeds from the sale of those shares goes back into the company.

Using your example, you have 10 out of 100 shares of the company, for a 10% stake. Let's say that the shares are valued at $1,000 each, meaning that the market value of the company is $100,000, and your stake is worth $10,000.

Now the company issues 100 more shares at $1,000 each. The company receives $100,000 from new investors, and now the company is worth $200,000. Your stake is now only 5% of the company, but it is still worth $10,000.

The authorized share capital is the amount of shares that a company has already planned on selling. When you buy stock in a company, you can look up how many shares exist, so you know what your percent stake in the company is. When a company wants to sell more shares, this is called an increase of authorized share capital. In order to do this, the company generally needs the approval of a majority of the existing shareholders.

share|improve this answer
10  
"Your stake is now only 5% of the company, but it is still worth $10,000." But then I'll receive only half of the dividends I was supposed to get when I bought the shares in the first place. The way a see it, they are selling for $10,000 a split of the stock that is mine. – lvella Jan 22 at 18:51
25  
@Ivella You may have the opinion that the increase of authorized share capital is a bad idea, and you can vote the way you think is best. But the idea behind it is that the company can use the increased investment to grow the company, making everyone's shares worth more and allowing for larger dividends. – Ben Miller Jan 22 at 18:54
9  
The company has indeed sold half of your ownership in exchange for new money. Presumably this new money was invested in the company (including your remaining ownership). If it has a rate of return on that investment is equal to that of existing projects, your expected dividends will not change (free cash flow will be high enough to pay you and the new shareholders the same dividend). Supposedly companies do this when they have opportunities that earn more than existing projects, in which case your dividends should go up. – farnsy Jan 22 at 19:21
8  
Note that the board of directors generally has a lot more stock than you do, so you have some assurance that they won't issue more stock lightly -- they don't want their ownership diluted unnecessarily either. – Russell Borogove Jan 22 at 19:40
3  
@Ivella I don't think there is any set amount of dividends that you were supposed to receive. The board of the company can decide how much dividend if any to pay out each year. Owning 10% of the company doesn't necessarily mean you get 10% of the profit every year because the company can keep its profits in a bank account or use them to buy new assets. – bdsl Jan 22 at 21:02

Stock dilution is legal because, in theory, the issuance of new shares shouldn't affect actual shareholder value. The other answers have explained fairly well why this is so.

In practise, however, the issuance of new shares can destroy shareholder value. This normally happens when the issuing company:

  1. Sells the newly issued shares at an undervalued price.
  2. Fails to use the proceeds from the sale in a way that enhances owners' wealth.

In these cases, the issuance of more shares merely reduces each shareholder's stake in the company without building proportional shareholder value.

share|improve this answer
2  
Furthermore, in practice the issuance of new shares can increase shareholder value, if the cash-rich version of the company is more valuable than the total of the cash-poor version of the company plus the cash. It's like a merger, but instead of being between two companies, it's between one company and one pile of green. Sometimes they work out and sometimes they don't. – Steve Jessop Jan 24 at 14:41
1  
@SteveJessop They work or they don't but usually the stock tanks because the assumption is that piles of green coming into the company means the company doesn't know how to make piles of green by itself. – gengren Jan 25 at 0:49

If that company issues another 100 shares, shouldn't 10 of those new 100 shares be mine?

Those 100 shares are an asset of the company, and you own 10% of them. When investors buy those new shares, you again own a share of the proceeds, just as you own a share of all the company's assets.

A company only issues new share to raise money - it is a borrowing from investors, and in that way can be seen as an alternative to taking on loans. Both share issuing and a loan bring new capital and debt into a company. The difference is that shares don't need to be repaid.

share|improve this answer
1  
That means that with the proceeds money I could buy the equivalent amount of new shares? – lvella Jan 22 at 18:58
16  
Just as much as you could go to your company's factory and take one of their lathes to sell and buy more shares. – The Photon Jan 22 at 19:06
4  
The issue of shares is not a borrowing from investors. – George Renous Jan 22 at 21:18
1  
Great answer! The "shares don't need to be repaid" as long as the company is a going concern. Practically, shareholders are the least 'senior' of a company's 'creditors' but, in the even of the company dissolving, shareholders are owed their portion of the proceeds (if any remain after repaying more senior creditors) from liquidating the company's assets. – Kenny Evitt Jan 23 at 17:52
1  
Stocks as assets made me realize, I don't own 5% of a company, I own 5% of the stocks: $100 of the company. If they issue more shares, I still own $100 of the stocks of the company. – Mooing Duck Jan 23 at 18:31

Alot of these answers have focused on the dilution aspect, but from a purely legal aspect, there are usually corporate bylaws that spell out what kind of vote and percentage of votes is needed to take this type of action. If all other holders of stock voted to do this, so 90% for, and you didn't, so 10% against, it's still legal if that vote meets the threshold for taking the action.

As an example of this, I known of a startup where employees got $0/share for their vested shares when the company was sold because the voting stock holders agreed to it. Effectively the purchase amount was just enough to cover debts and preferred stock.

share|improve this answer
1  
I would have answered the original question, why is stock dilution legal by saying it is legal because the board of directors, who have a fiduciary responsibility to the shareholders, have authorized it. That's part and parcel of OP only owning 10% of the company and the company needing a way to effectively manage the interests of all the owners when not all owners can be present for every decision. Hence managers, CxOs and boards. – Jerry Jan 25 at 1:21

Stock issuing and dilution is legal because there must be some mechanism for small companies to grow into big companies.

A company sees a great investment opportunity. It would be a perfect extension of their activities ... but they cannot afford it.

To get the necessary money they can either take out a loan or issue shares.

Taking a loan basically means that this is temporary, but the company will go back to being small when the loan is paid back.

Issuing new shares basically means that the Board means that this growth is permanent and the company will be big for the foreseeable future.

It is utterly necessary that companies have this option for raising cash, and therefore it is legal.

As detailed in the other answers, you end up with a smaller percentage of a larger company, usually ending up with more or less the same value.

share|improve this answer

For new shares to be successfully sold, the price has to be below market price. If you currently own shares of that company, you should always get an option to buy those newly sold shares at that discounted price. The number of options depends on the relative number of shares you hold.

Lets say you own 100 out of 1000 shares, currently priced at $10. 100 new shares are to be sold at $9. Since you are holding 10% of all shares, you have the option (i.e. the right) to buy 10 new (cheaper) shares (10% of 100) before anybody else can buy them. Theoretically, the money you save by getting the shares at a discounted price is equal to the money you lose by the share's value being diluted.

So, if you're a shareholder and the company is increasing it's capital, you're given the right to "go with it".

share|improve this answer

Your Answer

 
discard

By posting your answer, you agree to the privacy policy and terms of service.

Not the answer you're looking for? Browse other questions tagged or ask your own question.