Assume you own 10% of ABC Company’s* shares. The company could dilute (reduce) your ownership to less than 10%. The SIE exam focuses mainly on two dilutive actions:
*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. Authorized shares are the maximum number of shares the company is allowed to 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 they first offer stock to investors. That way, they can raise additional capital later by selling the authorized shares that remain.
Shares sold to investors are called issued shares. Once shares are issued, they trade in the secondary market among investors.
For example, suppose ABC Company authorizes 1 million shares but issues only 500,000 shares. If you purchase 50,000 shares, you have a 10% ownership position. In other words, you own 10% of the company’s outstanding shares.
Let’s pick up where we left off before the sidenote. You purchase 50,000 shares of ABC Company, which is a 10% ownership position.
Several years pass, and the company needs to raise additional capital. It still has authorized shares available to issue, so suppose it decides to issue the remaining 500,000 shares. That increases the number of outstanding shares and dilutes your ownership from 10% to 5%.
| Owned | Outstanding | Ownership | |
|---|---|---|---|
| Before | 50,000 | 500,000 | 10% |
| Diluted | 50,000 | 1,000,000 | 5% |
Your percentage ownership drops because the total number of outstanding shares increases while your share count stays the same. As a result, your voting power is cut in half.
To address this, companies generally can’t dilute existing owners without first giving current stockholders the chance to maintain their proportionate ownership.
This is the pre-emptive right. It gives you the right to buy newly issued shares before they’re offered to the public. If you owned 10% of the outstanding shares before the new issuance, you’ll have the opportunity to buy 10% of the new shares so you can keep the same ownership percentage.
The company distributes pre-emptive rights to current stockholders. Investors receive one right for every share of stock owned.
If you own 50,000 shares, you receive 50,000 rights. Each right has a specific value, and the offering will state how many rights are needed to buy one new share (for example, 5 rights per new share). You won’t be asked to infer missing information on the exam - questions will provide what you need.
For this rights distribution, we’ll keep it simple and assume:
Rights are issued with intrinsic value, meaning they provide an immediate economic benefit. Here, each right lets you buy a new share for $40 when the market price is $50. That’s a $10 discount, so each right has $10 of intrinsic value.
One reason companies can offer this discount is that they may avoid hiring an underwriter (an investment bank) to market and sell the new shares.
Underwriters help organizations market and sell their securities to investors. For example, when Facebook went public in 2012, it hired Morgan Stanley, JP Morgan, and Goldman Sachs as lead underwriters.
As a social media company, Facebook (now known as Meta Platforms, Inc.) didn’t have the resources or distribution network to sell its stock broadly in the securities markets. That’s why it hired large investment banks (underwriters). Underwriters are expensive; Facebook’s underwriters collected hundreds of millions of dollars for their services.
If a company can sell newly issued shares directly to current shareholders through a rights offering, it may not need to hire an underwriter. In effect, some of the savings can be passed to stockholders through a discounted purchase price.
Investors who receive rights generally have three choices:
Rights last for a short period and typically expire within 60-90 days of issuance. If you let them expire, you receive no benefit.
By offering pre-emptive rights, companies allow stockholders to maintain their percentage ownership of outstanding shares. A stockholder won’t be diluted if they exercise all their rights.
Now that we’ve covered how rights can help avoid dilution, let’s focus on convertible securities. In future sections, you’ll learn about convertible preferred stock and convertible bonds. For now, the key idea is that both can be converted into the issuer’s common stock.
Assume you own an ABC Company bond. Bonds pay interest to investors, which is one reason they’re valuable. If your bond is a convertible bond, you can exchange (convert) that interest-paying bond into ABC Company common stock.
If you choose to convert, you receive new shares of ABC Company, while other common stockholders do not. That’s why issuing convertible securities is considered a dilutive action.
Companies typically must obtain majority shareholder approval before issuing convertible securities. Why would stockholders approve dilution? The basic reason is cost savings.
Companies that issue bonds and preferred stock typically make semi-annual payments to investors. If those securities include a conversion feature, the issuer can often offer lower payment rates because investors are receiving 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) and then “pulls” back by reducing the payments made to investors. The less a company pays on its bonds or preferred stock, the more earnings (profits) it keeps.
One last dilutive action worth mentioning is when corporate issuers grant stock options to employees as part of executive compensation (for officers and directors). An option allows the purchase of stock at a fixed price. For example, a director might receive stock options that allow the purchase of company stock at $60 when the market price is $40. There’s no reason to exercise at that moment, but options are typically issued to encourage employees to increase productivity and sales.
If the stock price later rises above $60, the option becomes valuable (it gains intrinsic value). If this feels unclear, you’ll learn more about options in a future chapter. For now, remember that issuing stock options to employees is a dilutive action.
In conclusion, when a publicly traded company takes actions that dilute ownership, it must either offer a way to maintain proportionate ownership (such as pre-emptive rights) or obtain majority shareholder approval.
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