Penny stock investors will often hear the term dilution and assume the worst. Dilution is often viewed as a negative thing for an investment, but like most things in the stock market, it is a little more complex.

If the company needs more money after its initial public offering, it can sell even more shares to generate the funds it needs. Any newly issued shares are sold to investors, and the company uses the money for working capital, or to pay debts, or make an acquisition. Issuing new shares can decrease the proportionate value of each existing and new share, a result that investors call dilution.

If a company doubles the total number of shares, the amount of money each share represents drops in half. The most obvious reason for issuing more shares is to raise funds, but companies issue new shares for other reasons:.

Whether an IPO or a subsequent offering, this is an efficient way for any publicly traded company to generate funds. When the founder or organization owns too much of a company, she can easily lower that percentage of ownership by selling a portion to new shareholders by way of stock sale. Expanding the shareholder base: The more shareholders a company has, the better.

In fact, many of the major stock exchanges require that companies listing with them have a minimum number of unique shareholders. By issuing new shares into the market, the shareholder base expands as new owners purchase shares.

Dilutive effect of stock options ~ icoqerum.web.fc2.com

Paying executives and key employees: Companies regularly pay their key employees, or lure top talent, via shares or stock options. Penny stock companies are particularly fond of this maneuver because they may not have much cash to compensate executives but are able to offer shares that have potential to increase in value.

Cashing in options and convertible debentures: Sometimes new shares are created by using complex financial instruments.

For example, a convertible debenture is like a loan in which the creditor could be paid back the amount owed or could convert that value into new shares of the company instead. Options also become shares of the company if and when they are exercised, or cashed in. Issuing new shares can help a publicly traded company by giving it the greatest flexibility to take advantage of opportunities as it implements its business plan.

The benefits can be great, as long as the company is cautious of the potential for causing shareholder dilution. Dilution can have a detrimental impact on penny stocks. Any time a company issues new shares, the share of ownership of each stock is reduced. If it doubles the number of shares available, each one should be worth half as much.

Picture a company that trades at one dollar per share, while the number of outstanding shares doubles. If the shares are still at one dollar, but there are twice as many of them, that means the market capitalization has doubled. In this example, shareholders own stock in a company that has grown in size but may not see any increase in the stock price because there are so many more shares available.

They may be proud of the 20 percent gain their stock has returned so far, not realizing that this occurred during a time when the company significantly diluted its holdings.

Companies can also select the price at which they issue new shares or at which their options may be exercised. Setting a share price can be beneficial for shareholders if the price is higher than the current share price. Issuing new stock at prices lower than current share prices can have a negative impact on the stock.

In addition, current shareholders can also feel like they overpaid, or that management is giving away portions of the company at unfair levels. However, because dilution implies lower shares prices, when a company announces that it will be issuing more shares, investors may react immediately by selling their shares.

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Stock dilution - Wikipedia

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