This blog post discusses the concept of dilution in the context of shareholder ownership. Dilution occurs when new shares are issued, resulting in a reduction of the percentage of ownership held by existing shareholders. This can happen for various reasons, such as attracting new investors or rewarding employees with shares.
In relation to business ownership, one speaks of dilution when someone sees their percentage ownership of a company decrease.
Example of dilution
An example to clarify: Suppose you were to eat a sandwich on your own today. That whole sandwich then represents 100%. On day 2 you share a new sandwich with the two of you and you both eat half. Then you are 50% diluted. On day 3 someone else will join. You do not share your half of the sandwich from day 3, but you indicate that the newcomer should only get a quarter piece from your partner. So on this third day you do not dilute (you still have half of the sandwich), but your partner does dilute (he now also dilutes 50%). On day 4, someone else joins. Now everyone gives an equal piece of the sandwich to the fourth person. This means that all three previous bread eaters are diluted. How much they dilute depends on the size of the piece promised to the fourth person. When the fourth person should get a quarter of the whole sandwich, everyone gives a quarter of his or her piece. So all those quarters are not equal to each other, but together they make up a quarter of the whole sandwich, are you still following me?
From the sandwich analogy, the sandwich represents the whole company. Everyone can have a piece of that. When declaring shares, we actually make the sandwich bigger. We'll put that thing back in a fit that's a little wider, we'll press some more dough into it and bake it. Then we give that piece that has now been fried extra, to a new person. So the whole sandwich (the whole company) has been made bigger and a new person (investor) has got that new piece. In percentage terms, you have therefore become less owner of the sandwich with your original piece. However, the piece you own has not become smaller. This means that dilution need not be negative at all.
In principle, the law stipulates that dilution cannot simply take place. The existing shareholders of ordinary shares in a BV have a statutory pre-emption right upon the issue of new shares, in proportion to the existing percentage (see Section 2:206a of the Dutch Civil Code). If the general meeting of shareholders decides to issue shares, the existing shareholders can demand that shares be issued to them as well, so that the percentage remains somewhat stable. Of course, this can never be the case for everyone. When a new shareholder joins, that percentage has to come from somewhere. However, dilution can still occur in two cases.
The shareholder cannot or does not want to exercise his pre-emption right because he simply does not have sufficient funds to pay the issue price. When the resolution to issue shares by the general meeting excludes the pre-emptive right for certain shareholders.
No use of pre-emptive rights due to lack of resources
There is little you can do as a shareholder against the first situation. If you are unable to pay the price for the shares, then you are simply out of luck. In practice, this is an effective way for a wealthy majority shareholder to (further) reduce the interest of you, as a less wealthy minority shareholder. By issuing many shares – which you as a minority shareholder cannot afford – a significant dilution of the interest can be achieved. As a minority shareholder you can do nothing about it. Whether it's bad depends entirely on it. It may be that the large, wealthy shareholder puts so much money into the company that it experiences tremendous growth. It could then be that so much more profit is eventually made that your piece of that profit (no matter how small the percentage) is still worth more than before the dilution.
Exclusion of pre-emptive rights for certain shareholders
In the second case of dilution, the "prevention" becomes slightly more complex. By excluding the pre-emptive right in the general meeting, a majority shareholder can effectively bring about dilution. It no longer matters whether you, as a minority shareholder, have sufficient resources to pay for the shares. You simply cannot participate! However, a decision to exclude you as a minority shareholder may be contrary to the principles of reasonableness and fairness that shareholders must observe towards each other. In that respect, this is also an uncertain option for the majority shareholder: the validity of excluding the pre-emptive right is uncertain until it is examined by a court.
As a minority shareholder, you can prevent dilution by having a shareholders' agreement drawn up when entering into share ownership, which includes so-called anti-dilution clauses. An example of such a clause is that it is stated that the exclusion of pre-emptive rights can only be passed in the meeting by a vote with a 60+% majority or even with complete unanimity. This does not help you as a minority shareholder without financial resources, because dilution can occur even without a decision to exclude the pre-emptive right. In theory, as a minority shareholder you could have it included in the shareholders' agreement that dilution is never possible, even if no pre-emption right has been used. Anyway, this would mean that no new shares can be issued at all if you, as a minority shareholder, cannot participate financially. Everyone can see that that doesn't work. The chance then becomes very high, for example, that the majority shareholder or a new investor is not prepared to invest more money in the company. Well, then the whole thing will eventually dry up and you don't want that.
Look at the future
It's a bit of give and take. Fortunately, it is not very complicated in higher mathematics. Ultimately, I am convinced that you should look at the outcome of the dilution and not at the dilution itself. As stated, you may fall from 50% shares to 10% shares, but your effective profit may well increase from 1,000 euros to 10,000 euros. It remains a strange game, that capital market. One thing is clear: let's make sure that at least everyone can participate, majority or minority, it doesn't matter that much anymore.
How can our platform help you?
Share Council’s participation platform ensures that there is no need to think about administration after setting up the structure and selecting the contracts. Everything is arranged and maintained for you in the background. We have a range of payment plans available, so no matter what your budget is or how much time you have to spend on participation, we have a plan that will work for you.
To find out more about employee engagement, participation plans and how this can benefit your situation? Book a demo with our CEO.
You May Also Like
These Related Stories