The Dangers (And Benefits) of Share Dilution

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 |  Includes: IGTE, KAD, PIP
by: Marc Lichtenfeld

When public companies need more money, what are their options?

Sell more goods? Cut costs? Ask for a taxpayer bailout?!

Actually, there are several viable avenues they can take to get some extra cash. They can…

  • Sell bonds.
  • Tap into a line of credit. However, this increases their debtload. In turn, that results in higher interest payments (and lower earnings) and a more leveraged balance sheet.
  • Sell stock to the public. Like an initial public offering (IPO), companies can issue secondary offerings, where shares are sold and the proceeds go directly to the company.

But there’s a risk with taking this last approach…

The Dangers of Stock Dilution

When a company announces a stock offering, existing shareholders can see their holdings diluted as a result of a company selling more shares into the market. And it’s a hazard that many investors don’t often think about.

For example, let’s say small-cap company Western Widgets has one million shares outstanding and you already own 10,000 shares (or 1% of the company). The firm isn’t yet profitable and needs more cash to fund its operations. So management decides to sell 100,000 shares at $10 each, thus raising $1 million.

The company now has the money it needs to move forward. However, your 10,000 shares now only count for a 0.9% stake instead of 1% because you have 10,000 shares out of 1.1 million rather than the original one million. In short, you’ve seen your stake get diluted.

Additionally, the increase in the number of shares means Western Widgets’ earnings per share will be lower – and quite possibly the share price, too.

It works like this:

  • Let’s say Western Widgets has one million shares and earns $1 million. That translates to earnings per share of $1. If the average company in the sector trades for 20 times earnings, Western’s stock should trade at $20.
  • However, if Western sells 100,000 more shares into the market and now has 1.1 million shares outstanding, that $1 million in earnings now translates to $0.90 per share. And with an earnings multiple of 20, its share price would only be $18.

But it’s not necessarily a grim picture…

Raising Money the Wall Street Way

Early stage companies often need constant capital in order to get their businesses to the point where they’re self-sufficient.

But when market conditions are poor, a company may sell a small amount of stock, just to get the amount of cash they need in the short-term. They can then go back to the market for more capital when conditions are more favorable.

For example, rather than offering 10 million shares at $10, a company will perhaps only offer five million shares and be able to sell the other five million at $15 at a later date.

Early-stage biotech companies frequently take this approach. A firm can raise enough money to fund Phase I or II clinical trials and develop its drug pipeline – a process that may require several stock offerings.

But when the lead drug moves into Phase II, the company can then attract a lucrative partnership deal with a big pharmaceutical company. For example, it could receive $50 million upfront, plus future milestone payments, thus negating the need to raise money later on.

But what do these stock offerings mean for investors?

The Consequences of Stock Offerings

When a company announces a stock offering, its share price will usually fall.

We saw this last Friday when PharmAthene (AMEX: PIP), a bio-defense company, whose stock is in my First Access portfolio, said it would raise approximately $14 million by selling 4.3 million shares. This will dilute the existing shareholders’ positions by 13%. And sure enough, shares fell by 13% on the news.

That’s a fairly typical reaction.

  • Sometimes, though, raising capital this way can actually be a positive step – especially if the firm accompanies the move with some other source of capital-raising measure (like a line of credit, for example).
  • In these instances, the shares can move higher if the company manages to allay fears that it will run out of money or if investors feared a worse dilution.
  • And short-sellers expecting a stock offering may cover their positions (i.e. buy back their shares) on the news, too.

Case in point: Arcadia Resources (AMEX: KAD) – another of my First Access stocks – which also announced a capital raise last Friday. Shares actually rose, as investors cheered the news that the company now has enough money to fund its main source of growth – a prescription management business called DailyMed.

Stock Offerings on “Layaway”

Occasionally, you’ll also see a company file a “shelf registration.” This document signals the firm’s intention to offer a maximum number of shares up to three years in the future.

For example, iGate (Nasdaq: IGTE) recently said it plans to file a shelf for up to 10 million shares. However, it doesn’t necessarily have to sell that number. It could sell two million next month, another one million next year and never sell any more. Or it could sell all 10 million shares right away. Heck, it might never even sell a share.

It’s important to understand how share dilution can affect your holdings in the near term and the long term. So when you’re researching a company, become familiar with its cash position and burn rate (if it’s not profitable), as it can tell you whether it will likely need to raise money.

If you believe a stock offering is imminent, you’ll likely want to stay on the sidelines until after the latest round of dilution.

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