Assume you own 10% of ABC Company’s* shares. The company could dilute (or lessen) your ownership to a level lower than 10%. The SIE exam will focus primarily on two dilutive efforts: the issuance of new shares and the issuance of convertible securities.
*ABC Company is a fictitious, made-up company.
When a business is incorporated (becomes an official business), it establishes a specific number of authorized shares. These shares represent the number of shares a company can offer to investors. If ABC Company authorizes 1 million shares, it may issue up to 1 million shares of stock. Companies give up ownership (stock) in return for capital (money). Most companies sell only some of their authorized shares when first offering their stock to investors, which allows the company to raise additional capital later by selling the authorized shares left over.
Shares sold to investors are known as issued shares. Once shares are issued, they trade in the secondary market among investors. Let’s say ABC Company authorizes 1 million shares but decides to issue 500,000 shares. You, as an investor, purchase 50,000 shares, which is a 10% ownership position. You own 10% of the outstanding shares of this company.
Let’s pick up where we left off before the sidenote. You, as an investor, purchase 50,000 shares of ABC Company, which is a 10% ownership position.
Several years pass, and the company needs to raise additional capital. They still have 500,000 authorized shares to issue, so let’s say they decide to offer all of them. This action would dilute your 10% ownership down to 5%.
| Owned | Outstanding | Ownership | |
|---|---|---|---|
| Before | 50,000 | 500,000 | 10% |
| Diluted | 50,000 | 1,000,000 | 5% |
As you can see, your percent ownership of the outstanding shares dropped from 10% to 5% because the company wanted to sell more. When you vote now, your vote is worth half as much. It doesn’t seem fair, does it? Good news for you: companies generally can only do this after first offering the new shares to you.
This is called the pre-emptive right, which gives you the right to buy the newly-issued shares before they’re publicly offered. In our example, you owned 10% of the outstanding shares in the beginning. When the company issues new shares, you’ll have the opportunity to purchase 10% of the new shares to maintain the same ownership percentage.
How exactly does this work? The company issues pre-emptive rights to its current stockholders to purchase these new shares. Investors receive one right for every share of stock owned.
You owned 50,000 shares in the beginning, so you’ll gain 50,000 rights. Each right will have a specific value - for example, you may need 5 rights to purchase 1 full new share. Don’t worry about doing any math to figure this out, though. The questions you’ll see on the exam will give you this information.
For this rights distribution, we’ll keep it simple. Let’s assume the following:
Rights are issued with intrinsic value, which means they provide an immediate benefit. Each right allows a purchase of a new share for $40, which is $10 cheaper than its current market value of $50. In other words, each right is issued with $10 of intrinsic value. The company automatically provides this value because they’re saving money by avoiding the services of an underwriter (investment bank).
Underwriters help organizations market and sell their securities to investors. For example, when Facebook went public in 2012, they hired Morgan Stanley, JP Morgan and Goldman Sachs as their lead underwriters.
As a social media company, Facebook (now known as Meta Platforms, Inc.) didn’t have the required resources or network to sell its stock in the securities markets. That’s why they hired large investment banks (underwriters). Underwriters are not cheap; Facebook’s underwriters collected hundreds of millions of dollars for their services.
If a company can sell its newly-issued shares to current shareholders, it doesn’t need to hire an underwriter. Essentially, the savings are passed to stockholders by offering shares at a discounted price.
Investors receiving rights can choose one of three paths. Rights can be exercised, allowing the purchase of new shares at the exercise price ($40 in our example above). If an investor doesn’t want to spend money on new shares, they may sell the rights in the market. Remember, rights have intrinsic value, and another investor would be happy to purchase them for the right price. Last, investors can let the rights expire. Rights only last for a short period and typically expire within 60-90 days of issuance. Although it wouldn’t be wise, an investor could let them expire and not gain anything from them.
By offering pre-emptive rights, companies allow stockholders to maintain their percent ownership of outstanding shares. A stockholder will not be diluted if they exercise all their rights.
Now that we’ve thoroughly gone through the avoidance of dilution with rights, let’s now focus on convertible securities. In future sections, you’ll learn about convertible preferred stock and convertible bonds. We’ll avoid the specifics for now, but both securities are convertible into common stock of the same issuer.
Assume you own an ABC Company bond. Bonds pay interest to their investors, which is why bonds are valuable. The bond you own is a convertible bond, which means that you can turn your interest-paying bond into the common stock of ABC company. If you choose to convert, you will receive new shares of ABC company, while other common stockholders will not. This is why issuing convertible securities is considered a dilutive action.
Companies typically must obtain majority shareholder approval prior to issuing convertible securities. Why would stockholders approve of any dilution? The quick answer: to save money. Remember, stockholders are owners of the business and are invested in its success.
Companies issuing bonds and preferred stock typically make semi-annual payments to their investors. If they’re issued with conversion features, the issuer can offer lower payment rates because they’re being provided an added benefit (most bonds and preferred stock are not convertible). Some refer to this as the “push and pull” of the securities markets. The issuer “pushes” an added benefit to investors (the conversion feature), but then “pulls” back (or reduces) the payments made to investors. The less a company pays on its bonds or preferred stock, the more earnings (profits) they keep.
One last dilutive action worth mentioning involves corporate issuers offering stock options to employees, a typical form of executive compensation (for officers and directors). An option allows a purchase of stock at a fixed price. For example, a company director may be given stock options allowing the purchase of their company’s stock at $60 when the market price is $40. While there’s no point in exercising at that point, options are typically issued to provide incentives for employees to increase productivity and sales. The more successful the company, the higher the demand for its stock. If the stock price in our example rises above $60, the option is valuable (it gains intrinsic value). If you’re confused, we’ll learn more about options in a future chapter . Just keep in mind that issuing stock options to employees is a dilutive action.
In conclusion, when a publicly traded company attempts to dilute ownership, it must offer a form of resolution (like offering pre-emptive rights) or obtain majority shareholder approval.
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