The reduction in the percentage ownership of equity shares of the existing shareholders percentage in a company due to issuance of ‘new’ shares is known as equity dilution. These new of fresh shares can be issued either through an IPO (initial public offering) or Employee Stock Option Exercise. Thus, there are now more number of shareholders than earlier, meaning that equity is more dispersed and diluted.
Since number of shares outstanding increases, this also results in the share of the company’s profits being diluted. Total number of shares goes up but the Earnings remain the same for the company, so Earnings Per Share (EPS) goes down. This process may lower the share price of the company. In order to make sure that the share price remains intact or positive the company should ensure that the amount so raised is used for the growth in the company’s revenues and profits, improving the EPS. For example, if the funds raised via the new / fresh shares issued can lead to profits in the future by setting up new manufacturing plant, equity dilution is not viewed negatively. Also, hiring a senior resource like CEO or Managing Director for which sizeable ESOPs are issued can also be viewed positively due to the talent which the business gets, in addition to keeping employees motivated.
Now, let’s take an example of a company A Ltd. which started the operations with 1,00,000 shares owned by 100 unique shareholders i.e. each shareholder owned 1% of the company. In order to raise more capital, the company issued 10,000 new shares to 10 new shareholders. So now 110 shareholders own 0.9% of the company each. This has resulted in 9.1% equity dilution, with each shareholder having slightly less voting power.
Equity dilution = 10 / 110 = 9.1%