Today’s article follows the theme of last week’s article and the week prior’s article concerning equity compensation, but can also be applicable even if you don’t receive equity as part of a compensation package.
The subject is: dilution.
The word itself may bring to mind high school chemistry class, or perhaps just making the last bit of dish soap go a little further by putting some water in the container with it.
The concept in investing is the same - taking something that was concentrated and “spreading” it out.
Specifically, this applies to stock and ownership in a company (affecting shareholders’ voting rights and the value of the shares themselves).
An example can help make the concept clearer:
Say you decide to take a job at a startup-type company and part of your compensation is equity in the company - 10% “ownership” through a grant of 1,000 of the 10,000 total not-publicly-traded company shares.
These shares may or may not have any actual value now, but you’re confident that in a few years, the company will IPO and 10% ownership in the company will translate to some amount of money significant to you.
Unfortunately, you may not realize that unless there are specific provisions in your ownership of the shares, even though you “own” 10% of the company now, you may not own 10% of the company a week from now, much less when it IPOs.
This is because companies can issue new shares of stock - essentially create them out of thin air - and sell them for various purposes.
(As the subtitle alludes to, this is kind of like the government “printing” new money, effectively decreasing the value of all the money that already exists - something I touched on in an article a few months ago.)
To use concrete numbers and an example with food - say you accept 1,000 shares of stock and there are 10,000 total shares - you effectively “own” 10% of the company “pie”.
To further illustrate what’s happening, let’s say this is a 1 kg pie, so your ownership amounts to .1 kg of pie (yum!).
As your company increases in value, the weight of the pie increases - now it’s 2 kg and since you own 10% of the pie, you own .2 kg worth of pie - this .2 kg is the “dollars” you’d be able to get if you sold the pie.
At some point in the future, your company decides it needs “cash” (to fund growth, pay for acquisitions, hire talent, etc.) so it creates another 10,000 shares.
Now there are 20,000 total shares and while you still own 1,000 shares your “piece of the pie” dropped from 10% of the total down to 5%.
If the pie is still 2 kg, you now only own .1 kg of pie - your share of the whole pie was essentially just cut in half.
If you didn’t know about this possibility, it could be quite shocking to you and leave you feeling shortchanged.
This raises the question - why do companies do this?
If it’ll just leave employees and investors feeling swindled and shortchanged due to their reduced ownership, what’s the benefit?
In short the benefit is this: ideally the “proceeds” from those new shares will allow the company to grow in ways that are generally seen as valuable.
If this growth occurs and value is added, this contributes to the “weight” of the pie.
So, in this example, if by creating 10,000 new shares the company is able make the pie increase in weight by 8 kg, as long as you’re only considering the financial aspect of company ownership (i.e. not voting or anything similar), that’s a huge win: your 10,000 shares may only account for 5% of the company’s ownership but now “weigh” .5 kg, much more than the prior .1 kg, or even the .2 kg immediately prior to the new share creation.
(Note that financial value isn’t the only reason to own shares - generally share ownership means you have a “voice” in the company’s decision making through “voting”, so if that’s important to you it’s something to consider as new shares may dilute your voting power in ways that increased share value may not compensate for.)
So, if you own stock, the lesson of the day is: your stock doesn’t necessarily represent a fixed percentage ownership in the underlying company, nor does it represent a fixed voting power.
It also isn’t safe to project your stock’s value into the future based on the company’s growth and performance because even though the number of shares you own may not decrease over time, the number of shares you don’t own may increase over time.
And, if all you got out of this was “10 kg pie”, well… don’t eat it all at once. :)