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What I always heard, since I was a child, was that if you own a stock share, you actually own a small share of a company. That seems to be the general consensus of what a stock share is.

Well, that said, let's assume I have 10 out of 100 shares of a company. If that company issues another 100 shares, shouldn't 10 of those new 100 shares be mine? Apparently it is not, and my ownership of the company is halved. How can they take 5% of the company from me without paying its due value? Shouldn't it be illegal?

I am certain I have some misconceptions on how these things work. How is it really done?

Ben Miller
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lvella
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7 Answers7

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Theoretically, when a company issues more shares, it does not affect the value of your shares. The reason is that when a company issues and sells more shares, the proceeds from the sale of those shares goes back into the company.

Using your example, you have 10 out of 100 shares of the company, for a 10% stake. Let's say that the shares are valued at $1,000 each, meaning that the market value of the company is $100,000, and your stake is worth $10,000.

Now the company issues 100 more shares at $1,000 each. The company receives $100,000 from new investors, and now the company is worth $200,000. Your stake is now only 5% of the company, but it is still worth $10,000.

The authorized share capital is the amount of shares that a company has already planned on selling. When you buy stock in a company, you can look up how many shares exist, so you know what your percent stake in the company is. When a company wants to sell more shares, this is called an increase of authorized share capital. In order to do this, the company generally needs the approval of a majority of the existing shareholders.

Ben Miller
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Here's another way that I look at it:

Say you and me were 50-50 partners in a small business. Suppose we wanted to expand our business but that needed money. Someone (let's call him Warren) has the money we need & hence in return for the money we offer Warren an equal stake in the business.

i.e. All three of us own 33% stake now. For both you and me our stake reduced from 50% that it was before Warren's entry to only 33% now.

While that reduction in our share may seem at first sight a bad deal for us, we both agreed to give Warren his share consciously not out of altruism but because it made business sense to helps us expand.

Ergo, what matters is not just your share of the pie but the size of the pie itself! And hence dilution of stake can make sense under certain circumstances.

Two small points:

(a) This doesn't in any way show the dilution must make sense. Only that it can sometimes make sense

(b) Of course, in the case of a large corporation they do not need your personal approval for the dilution. But hey, neither do they ask you when they buy a new plant or start a new product.

curious_cat
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Stock dilution is legal because, in theory, the issuance of new shares shouldn't affect actual shareholder value. The other answers have explained fairly well why this is so.

In practice, however, the issuance of new shares can destroy shareholder value. This normally happens when the issuing company:

  1. Sells the newly issued shares at an undervalued price.
  2. Fails to use the proceeds from the sale in a way that enhances owners' wealth.

In these cases, the issuance of more shares merely reduces each shareholder's stake in the company without building proportional shareholder value.

Zenadix
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If that company issues another 100 shares, shouldn't 10 of those new 100 shares be mine?

Those 100 shares are an asset of the company, and you own 10% of them. When investors buy those new shares, you again own a share of the proceeds, just as you own a share of all the company's assets.

A company only issues new share to raise money - it is a borrowing from investors, and in that way can be seen as an alternative to taking on loans. Both share issuing and a loan bring new capital and debt into a company. The difference is that shares don't need to be repaid.

Kirk Broadhurst
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Alot of these answers have focused on the dilution aspect, but from a purely legal aspect, there are usually corporate bylaws that spell out what kind of vote and percentage of votes is needed to take this type of action. If all other holders of stock voted to do this, so 90% for, and you didn't, so 10% against, it's still legal if that vote meets the threshold for taking the action.

As an example of this, I known of a startup where employees got $0/share for their vested shares when the company was sold because the voting stock holders agreed to it. Effectively the purchase amount was just enough to cover debts and preferred stock.

davmp
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Stock issuing and dilution is legal because there must be some mechanism for small companies to grow into big companies.

A company sees a great investment opportunity. It would be a perfect extension of their activities ... but they cannot afford it.

To get the necessary money they can either take out a loan or issue shares.

Taking a loan basically means that this is temporary, but the company will go back to being small when the loan is paid back.

Issuing new shares basically means that the Board means that this growth is permanent and the company will be big for the foreseeable future.

It is utterly necessary that companies have this option for raising cash, and therefore it is legal.

As detailed in the other answers, you end up with a smaller percentage of a larger company, usually ending up with more or less the same value.

Stig Hemmer
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For new shares to be successfully sold, the price has to be below market price. If you currently own shares of that company, you should always get an option to buy those newly sold shares at that discounted price. The number of options depends on the relative number of shares you hold.

Lets say you own 100 out of 1000 shares, currently priced at $10. 100 new shares are to be sold at $9. Since you are holding 10% of all shares, you have the option (i.e. the right) to buy 10 new (cheaper) shares (10% of 100) before anybody else can buy them. Theoretically, the money you save by getting the shares at a discounted price is equal to the money you lose by the share's value being diluted.

So, if you're a shareholder and the company is increasing it's capital, you're given the right to "go with it".

Thomas
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