Closely Held Corporations: Dilution

Jul 18, 2018 | Business

A corporation is free to create and sell more stock unless there is something in writing saying it may not.

Shareholders need to be mindful of dilution of their voting power and ownership when new stock is issued. If a corporation has 100,000 shares, a shareholder who owns 50,000 shares holds 50% of the voting power and ownership. If the corporation issues another 100,000 shares, the shareholder then holds 25% of the voting power and ownership.

Dilution can reduce both the power of the shareholder to control the corporation and reduce the shareholder’s return on investment. To address the issuance of additional shares, there are two obvious options.

The first option is to prohibit the corporation from issuing new shares without the consent of all shareholders. This prevents any shareholder’s ownership interest from being diluted without their consent. The downside with this approach is it can lead to tyranny by the minority. One shareholder can prevent the corporation from raising capital by issuing shares of stock.

The second option is to require majority (50%) or supermajority (66.6%) approval from the shareholders for a corporation to issue more stock. This gives the majority the power to decide whether more stock should be issued. The downside with this approach is it is a tyranny by the (super)majority. The minority shareholders are along for the ride.

There are other ways to prevent dilution. A new shares could be a different class of stock or the existing shareholders are given the right to buy more stock from the offering to prevent dilution.

No matter how it is dealt with, the shareholders should carefully consider how and when a corporation may issue new stock.