How does stock dilution work in relation to share volume?

Question

I'm aware of stock splits/reverse splits used for modifying volume of a stock, but how often are they actually used? Isn't it less common that a company simply decides to sell more stock at the market price?

What protections are there for an investor to prevent a company from simply declaring that the stock I have that used to entitle me to 1/10,000 of the company now only entitles me to 1/100,000 simply because they want to sell 90,000 more stocks?

Answer 1

Here is an example for you. We have a fictional company. It's called MoneyCorp. Its job is to own money, and that's all. Right now it owns $10,000. It doesn't do anything special with that $10,000 - it stores it in a bank account, and whenever it earns interest gives it to the shareholders as a dividend. Also, it doesn't have any expenses at all, and doesn't pay taxes, and is otherwise magic so that it doesn't have to worry about distractions from its mathematical perfection. There are 10,000 shares of MoneyCorp, each worth exactly $1. However, they may trade for more or less than $1 on the stock market, because it's a free market and people trading stock on the stock market can trade at whatever price two people agree on.

Scenario 1. MoneyCorp wants to expand. They sell 90,000 shares for $1 each. The money goes in the same bank account at the same interest rate. Do the original shareholders see a change? No. 100,000 shares, $100,000, still $1/share. No problem. This is the ideal situation.

Scenario 2: MoneyCorp sells 90,000 shares for less than the current price, $0.50 each. Do the original shareholders lose out? YES. It now has something like $55,000 and 100,000 shares. Each share is now worth $0.55. The company has given away valuable equity to new shareholders. That's bad. Why didn't they get more money from those guys?

Scenario 3: MoneyCorp sells 90,000 shares for more than the current price, $2 each, because there's a lot of hype about its business. MoneyCorp now owns $190,000 in 100,000 shares and each share is worth $1.90. Existing shareholders win big! This is why a company would like to make its share offering at the highest price possible (think, Facebook IPO). Of course, the new shareholders may be disappointed.

MoneyCorp is actually a lot like a real business! Actually, if you want to get down to it, MoneyCorp works very much like a money-market fund. The main difference between MoneyCorp and a random company on the stock market is that we know exactly how much money MoneyCorp is worth. You don't know that with a real business: sales may grow, sales may drop, input prices may rise and fall, and there's room for disagreement - that's why stock markets are as unpredictable as they are, so there's room for doubt when a company sells their stock at a price existing shareholders think is too cheap (or buys it at a price that is too expensive).

Most companies raising capital will end up doing something close to scenario 1, the fair-prices-for-everyone scenario.

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Legally, if you own part of a company and they do something a Scenario-2 on you... you may be out of luck. Consider also: the other owners are probably hurt as much as you are. Only the new shareholders win. And unless the management approving the deal is somehow giving themselves a sweetheart deal, it'll be hard to demonstrate any malfeasance. As an individual, you probably won't file a lawsuit either, unless you own a very large stake in the company. Lawsuits are expensive. A big institutional investor or activist investor of some sort may file a suit if millions of dollars are at stake, but it'll be ugly at best.

If there's nothing evil going on with the management, this is just one way that a company loses money from bad management. It's probably not the most important one to worry about.

Answer 2

The reason a company creates more stock is to generate more capital so that this can be utilized and more returns can be generated. It is commonly done as a follow on public offer. Typically the funds are used to retire high cost debts and fund future expansion.

What stops the company from doing it?

• The decision has to be approved by majority share holders. So its not really done for fun or to cheat small investors.
• of course there are guidelines and declarations that a company has to make as to how it plans to utilize the newly raised capital.

Are Small investors cheated?

• Not really. In the example you gave, the share of the ownership may have gone down in percentage terms, but in real money value, you are still entitled to the same value.
• For example if the initial 1 Share was worth USD 10, even after the company issues more shares for USD 10 ea, your value is still USD 10.
• If you need to retain the same percentage, you need to buy 9 more shares.
• In the long run it may be more beneficial for you as the new capital may be used for more growth and more revenue.

It's like you have joined a car pool with 4 people and you are beliving that you own 1/4th of the total seats ... so when most of them decide that we would be better of using Minivan with 4 more persons, you cannot complain that you now only own 1/8 of the total seats. Even before you were having just one seat, and even after you just have one seat ... overall it maybe better as the ride would be good ... :)

Answer 3

Let me answer with an extreme example - I own the one single share of a company, and it's worth $1M. I issue 9 more shares, and find 9 people willing to pay $1M for each share. I know find my ownership dropped by 90%, and I am now a 10% owner of a business that was valued at $1M but with an additional $9M in the bank for expansion. (Total value now $10M)

Obviously, this is a simplistic view, but no simpler than the suggestion that your company would dilute its shares 90% in one transaction.