How Dilution Works

dilution
Dilution

Dilution at Acme, Inc.

Suppose Acme, Inc. has 1,000,000 total shares outstanding and a tangible book value of $100 million. That means its tangible book value per share is $100,000,000 ÷ 1,000,000 = $100. Therefore, if you buy one share of Acme for $5, you’re paying $5 for a claim to $100 of tangible book value.

Harmless dilution

Suppose that instead of receiving nothing for 1,000,000 newly issued shares, Acme receives $100 per share from an investment bank that underwrites an offering for the company. Although Acme’s total shares outstanding increase to 2,000,000, the cash raised in the offering increases the company’s tangible book value to $200,000,000. Therefore, after the offering, Acme’s tangible book value per share remains $200,000,000 ÷ 2,000,000 = $100.

Dilution while cash poor

However, suppose that after raising $5,000,000, Acme has a cash balance of only $5,500,000. The company uses about $1,000,000 per year simply to pay rent, payroll, and other recurring expenses. Despite management’s grand vision, Acme won’t have enough cash to develop a new product without raising more money, which means issuing more dilutive shares. Once investors figure that out, Acme’s stock price may begin to slide.

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