Dilution is a subject that comes up quite frequently in and around the world of marijuana stock investing. The cannabis industry is young and that means that most of the companies are at the stage in their lifecycle where they need capital to grow and when they are doing deals to grow. Dilution happens whenever companies issue new shares (or issue securities that can become new shares, including employee stock options, warrants and convertible bonds).
What is dilution?
Sorry if you are hungry right now, but the easiest way to grasp the concept of dilution is to imagine the company as a whole pie, and each of the company’s shares as the slices of this pie. Initially, the pie has four slices (shares) and you have one of them, or 25% of the whole pie. Then four friends show up wanting pie, so the whole pie gets cut into eight slices. Everybody gets a slice, but now everyone’s slice is only 12.5% of the pie. When the number of slices increases (assuming the pie remains the same size) each person gets a proportionally smaller slice of pie. This is the same thing that happens when companies issue new shares. After the stock issuance, each share represents less of the whole company than it did before.
What Causes Dilution?
Simply put, dilution will result from any activity that has the end result (or could have the end result) of the issuance of new shares of company stock. Common corporate actions that lead to dilution include:
It’s Not All Bad
Don’t run off thinking dilution is a terrible thing, because it’s not. Sometimes dilution can happen due to decisions that produce more good than the bad that came from dilution. Going back to our pie example, say the pie doubled in size before the four more people showed up, then you would have ⅛ of the pie, but the ⅛ you have is the same size as the ¼ you had initially. Now this is an exaggerated example, but it gives you an idea how dilution can be good if it is accompanied by an increase in the value of the company. Let’s look at a two hypothetical cases where dilutionary transactions end up benefiting shareholders.
Acquisition Paid For in Company Stock
If a company issues new shares (dilutionary) to purchase another company, it can be a good thing. If the acquisition improves the company's competitive position or leads to significant synergies, the benefit of the acquisition can be greater than the detriment of the related dilution. In these cases, although shareholders have a smaller percentage of the company, that percentage can end up being worth more because of the financial and strategic benefits of the deal. Additionally, if the company’s stock is overvalued it can be better to use stock as opposed to cash, because effectively the company will be getting a deal.
Secondary offerings are another time where a dilutionary transaction can actually lead to a better outcome for shareholders. Though this time you really need to pay attention. Secondary offerings can be no good if they are being used to pay expenses as a last resort or fund executive perks in excess. That said, if a secondary offering is used to raise capital that funds growth through the purchase of assets or funds effective research and development, it can increase the size of the pie for everyone.
It’s important for marijuana stock investors to be mindful of dilution. Don’t run away from it (it’s just part of the market) but be aware of the reasons behind any dilutionary transaction. We hope this helped you know what it means when you see a transaction labeled as non-dilutionary or when a company does a secondary offering.
To stay posted on important cannabis updates, be sure to subscribe to one or more of our free newsletters. Also, don't forget to connect with The Daily Marijuana Observer on Facebook, Twitter, and Instagram.