Stock Dilution

Stock dilution occurs whenever additional shares of common stock enter the market place. This issuance causes a reduction in the earnings per share of common stock because the same amount of profit must be distributed over more shares.

Additional shares can enter the market place through a public offering, employees exercising stock options, or by the conversion of preferred stock shares, bonds, or warrants into stock.

Dilution may shift stock ownership in desirable or undesirable ways from a corporate perspective. For example voting control, earnings per share, or the value of shares may change based on dilution and often forces stock value below the IPO price.

Control Dilution

Control dilution occurs when the current owners of a corporation experience a reduction in the percent of their ownership in the corporation. Venture capital firms raise additional capital and avoid dilution by equally giving warrants to all existing shareholders.

The warrants allow investors to put more money in the corporation or lose ownership percentage. Additionally, if an employee attempts to dilute ownership of the control group the corporation can use cash to buy back issued shares.

Options and warrants convert at pre-defined rates. As stock per share price increases, so do both options and warrants at the same rate. For example if stock increases by one dollar so does a call and warrant linked to that stock.

Earnings Dilution

As previously mentioned, earnings dilution occurs when the amount of net income earned per share is reduced because of additional issued shares.

Value Dilution

Value dilution occurs when the value declines because of the increase of shares issued in the market place.

Profit Sharing

In publically traded companies— and often in companies that intend to go public– incentive plans are put in place to create a climate of motivation where employees are incented to reach specific and defined performance goals. These incentive plans provide for either an immediate payment of cash and/or stock, or longer-term compensation with bonus and possibly employee stock options. In privately held companies compensation is usually in the form of salary and bonus.

Profit sharing is usually based on a predetermined agreement that outlines how profits and possibly shares of stock are divided between the company and the employee, and stipulates terms and conditions attached thereto.

Employee Stock Options

An employee stock option (ESO) is a call option on publically traded company stock given to an employee as part of a private compensation agreement between the employee and company, with the intent to motivate the employee to do everything they can do to increase the company’s stock price.

A call option gives the holder the right to:

1. Buy stock at a set price, or

2. Sell the option at a set price.

In application, an employee holding a stock option has these same rights.

Management and company executives are most often the employees to receive stock options but options may be offered to all levels of employees and are often offered to induce good employees to stay or work harder when the company is in early stages of development and unprofitable. In fact stock options may be offered to anyone and everyone– from suppliers, all the way to promoters.

Depending on the vesting schedule and the maturity of the options, the employee may elect to exercise the options at some point, obligating the company to sell the employee its stock at whatever stock price was used as the exercise price. At that point, the employee may either sell the stock, or hold on to it in the hopes of further price appreciation, or hedge the stock position with listed calls and puts.

The company may set prerequisites before an employee can exercise their rights on a call option.

For example the company may have an employee vesting schedule and require the options to be a certain age.

After these requirements are met then the employee can:

1. Sell the stock,

2. Hold the stock anticipating future price improvements or as a stockholder in the company.

Call options are placed a distance away from the current stock price which means the stock may need to increase significantly, on a percentage basis, for the employee to be able to exercise the call option. If the stock did reach the predetermined price (“strike price”) of the call option, then the employee could exercise that option and require the company to sell them stock at the preset price.

If the stock does not increase or decreases in value then the employee has no obligation to do exercise the option.

Dr. Brent Lundell owns http://www.GainStreamGroup.com, a venture capital sourcing and consulting company, and is a partner in The Guinn Consultancy Group, Inc. The Guinn Consultancy Group provides a wide array of business services, including seminars, webinars, and venture capital sourcing services. See the group website at www.theguinnconsultancygroup.com or contact them for additional information at 800-335-9269.

Dr. Brent Lundell owns http://www.GainStreamGroup.com, a venture capital sourcing and consulting company, and is a partner in The Guinn Consultancy Group, Inc. The Guinn Consultancy Group provides a wide array of business services, including seminars, webinars, and venture capital sourcing services. See the group website at www.theguinnconsultancygroup.com or contact them for additional information at 800-335-9269.

Author Bio: Dr. Brent Lundell owns http://www.GainStreamGroup.com, a venture capital sourcing and consulting company, and is a partner in The Guinn Consultancy Group, Inc. The Guinn Consultancy Group provides a wide array of business services, including seminars, webinars, and venture capital sourcing services. See the group website at www.theguinnconsultancygroup.com or contact them for additional information at 800-335-9269.

Category: Finances
Keywords: Finance,Business Funding,Venture Capital,Business