Dilution
Dilution: A Primer of Vocabulary
In the past I have had discussions with entrepreneurs and investors about the concepts of "Dilution" and "Valuation". Because there are often misconceptions about these terms, so here they are clarified.
Dilution.
Dilution connotes a decrease in something. As applied to stock there are at least two dilution concepts- a decrease in percentage ownership of a company (Percentage Dilution) or a decrease in the economic value of an investment (Economic Dilution).
Percentage Dilution.
If Bill Gates owns 1,000 shares of Microsoft which represents 100% of the issued and outstanding stock and Microsoft issues 1,000 shares to Paul Allen, then Bill Gates' has experienced Percentage Dilution in his ownership from 100% to 50%.
Economic Dilution.
Note that a Percentage Dilution in stock ownership has no direct relationship to the value of that stock ownership position. The Board of Directors of a company is supposed to determine that the company has received fair value for the stock it issues. Of course, the "value" of the stock can go up and down over time. So if Bill Gates paid $1 per share for his 1,000 shares and Paul Allen comes along and buys 1,000 shares from Microsoft at a price of $2 per share, then Bill Gates has experienced a Percentage Dilution but his economic position has been increased from his initial position. On the other hand, if Paul Allen buys his Microsoft stock at a price of $.75 per share then Bill Gates has experienced both Percentage Dilution and an Economic Dilution from his initial $1.00 purchase price. Dilution from an initial price is different than dilution from the current price. For example, a sale at $.75 per share would not represent an Economic Dilution from current value if the fair market value of the stock was $.50 per share at the time Paul Allen purchased and conversely, if Paul Allen paid $2.00 per share there would be an Economic Dilution from current...
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