Top Stories | Mon, 23 Dec 2024 04:32 PM

How Companies Obtain Funding Through Diluted Shares

Posted by : SHALINI SHARMA

Corporate finance is an important area in which funding is very essential for businesses to expand, develop new products, or meet operational needs. The most common way that companies raise funds is by issuing new shares to investors, thereby diluting the ownership of existing shareholders. This way of raising capital by firms is done without additional debt; however, the price that follows can be too cost-effective. We will delve in-depth in this blog about how companies obtain funding with diluted shares, how this process works, and how it is viewed by investors as well as the company.

•What does Share Dilution mean?

Share dilution happens when a company issues more shares. The result is that the ownership percentage of existing shareholders decreases. Even though the total value of the company may increase with the injection of capital from the new shares, the individual stake of current shareholders is diluted.

For instance, suppose a firm has 1 million outstanding shares, and an investor owns 100,000 shares. Then, if the firm wants to issue 500,000 new shares, its outstanding shares will now be 1.5 million. The percentage of ownership by the investor decreases from 10% (100,000/1,000,000) to 6.67% (100,000/1,500,000), but the investor did not sell any of his or her shares.

•Why do firms issue diluted shares?

The primary reason companies issue diluted shares is to raise capital. Unlike debt financing, which involves taking loans and incurring interest expenses, equity financing, through the issuance of shares, gives companies funds in exchange for ownership stakes. Here are some key reasons companies opt for this method:

Funding for Growth: Companies looking to expand their operations, research new technologies, or enter new markets often require significant capital. They can raise funds without incurring debt, which is costly in terms of interest payments and financial risk, by issuing new shares.

Debt Burden Reduction: If the company has high debt levels, then the company may use this opportunity to reduce its leverage ratio by issuing more shares. They can raise equity, pay off existing debt with it, and thereby improve the balance sheet and health of the companies Acquisitions: Companies often issue new shares to finance acquisitions. Instead of paying in cash, they offer equity in their own company as part of the acquisition deal, which allows them to grow without depleting their cash reserves.

Employee compensation plans involve offering stock options or restricted stock units to employees. When the employees exercise their stock options, there is a new issuance of shares, which dilutes the existing shareholders. Many tech companies use this plan because it is one of the incentives offered to attract top talent in a firm.

Public Market Raising Capital: When a company issues its initial public offering (IPO) or later, through follow-on offerings, it sells shares to the public. The money realized from such offerings is put to business use, for instance, to expand the business or to develop a new product.

•The Issuance Process of Diluted Shares

The issuance of diluted shares involves a planning, legal procedure, and an approval process. Below are the main steps involved in this process:

Board Approval: The company's board of directors must approve new issues of shares. It is a decision that needs proper deliberation since it impacts the financial structure of the company as well as its shareholders.

Shareholder Approval: In most instances, the company requires approval from the existing shareholders to issue new shares, especially in major equity offerings or changes in capital structure. This is normally done through a vote at the AGM or a special meeting.

The company will then determine the number of new shares it intends to issue based on its capital needs. In most cases, the number of shares issued has a direct correlation to the amount of funding required and the current share price.

Pricing the Shares: Pricing is perhaps the most crucial issue in issuing new shares. The companies usually price the new shares at a slight discount to the prevailing market price to attract the investors. This ensures there is a demand for the newly issued shares and the company raises the desired amount of capital.

Regulatory Approval: In many jurisdictions, firms are required to file with financial regulatory bodies, like the SEC in the United States, before issuing new shares. This provides an openness through which investors make their informed decisions.

Market Offering: The firm can opt to do a private placement (where shares are sold to a selected few institutional investors) or public offering (shares are sold on the open market). The company may hire investment banks or brokers to assist in the process.

•Consequences of Diluted Shares to Investors

While issuing new shares can be a huge boon for a company, it may have mixed effects on investors. Here are the key implications:

Ownership Percentage: The most obvious impact of share dilution is the reduction in ownership percentage for existing shareholders. If the company issues a large number of shares, this can significantly impact the control that existing shareholders have over the company.

Potential Share Price Drop: The introduction of new shares can bring about a surge in the share supply that, at least in the short term, may depress the share price. This may be the case since the EPS of the company will now be lower because there are more outstanding shares, thus a lower valuation.

Voting Power: Those shareholders who have reduced the percentage of ownership may lose some or all of their voting power. This is a matter of concern for investors in companies with concentrated ownership as it would limit their influence in matters of company decisions.

Future Dividends: Shareholders may experience a decline in future dividend payments per share since the company may now have a larger pool of shares to distribute dividends to. This is particularly a concern for dividend-focused investors.

Dilution and Capital Needs: The greatest challenge to companies is the balance between raising enough funds and minimizing the effects of dilution. Over-dilution can result in loss of investor confidence, decreased stock prices, and discontent among existing shareholders. On the other hand, under-dilution leaves the company with insufficient funds to achieve its objectives, potentially jeopardizing its growth prospects.

•Alternatives to Diluted Share

There are various alternatives to new issues for capital raised, such as the following.

Debt Financing: This method involves the raising of money through bonds, loans, or lines of credit. This helps in avoiding dilution but increases the financial leverage and often incurs greater costs on account of interest payments.

Convertible Securities: Some firms issue convertible bonds or preferred shares that are convertible into common stock at some later date. This way, the company receives the capital at issue but postpones dilution until conversion.

Strategic Partnerships: Companies can form strategic partnerships or joint ventures to share resources and gain access to funds without issuing new shares. This is usually a partnership with other companies where both parties benefit.

•Conclusion

The capital of companies can be raised using the issuance of diluted shares to support growth and long-term success. But it is also necessary that the company and the investors understand the dilution effect on ownership, value, and voting power. Care should thus be taken by the company when carrying out the process of dilution so that the current shareholders are not alienated and the value of their stocks is not undermined. Understanding how dilution works is quite important for investors in making smart decisions on their investments, thus reducing the risks and possible consequences.

Share dilution represents a trade-off between immediate capital needs and long-term ownership interests. Companies that can strike this balance will be well-positioned to thrive, while investors who grasp the nuances of diluted shares will be better prepared to navigate the ever-changing world of finance.