This browser is not actively supported anymore. For the best passle experience, we strongly recommend you upgrade your browser.
Welcome to Reed Smith's viewpoints — timely commentary from our lawyers on topics relevant to your business and wider industry. Browse to see the latest news and subscribe to receive updates on topics that matter to you, directly to your mailbox.
| 1 minute read

The various forms of "dilution"

You likely learned about dilution in high school chemistry and the idea that, when you add more of one thing to another, you decrease the concentration. Finance has a similar concept of equity dilution – when a company issues more shares of stock (or limited liability company membership interests, or partnership interests), the existing owners own a smaller percent of the total (unless they buy the new shares). For example, if I own 10 shares of a CBD knish company that has issued 100 shares, I own 10% of that company. If the company then sells an additional 100 shares to build a second plant, I now own 10 out of 200 shares, or only 5% of the CBD knish company – my equity ownership has been diluted.

Tapping the equity markets to raise additional working capital has its benefits relative to borrowing money – among other things, the company does not have to pay the money back, pay interest, or risk default on the loan. However, issuing additional equity to new buyers results in dilution of the existing shareholders – the denominator (being the total amount of equity outstanding) is now bigger. There are ways for existing holder to protect themselves, such as exercising preemptive rights (the right to purchase a pro rata share of an equity issuance to maintain percentage ownership), if they exist.

As equity capital markets have tightened for the cannabis industry, more companies that have the capacity (generally, sufficient underlying assets to get a lender comfortable that the loan could be paid back) have turned to the debt markets for working capital. One of the benefits of a loan is that it is a way to inject additional cash into the company without equity dilution (unless the lender takes warrants or other equity as additional payment for making the loan). So if the CBD knish company borrows the money to build that second plant, I will still own 10% of the company.

However, taking on debt does result in profits dilution. Loans involve periodic interest payments, fees (such as annual maintenance fees, unused borrowing fees), and potentially prepayment premiums (meaning an additional payment if the loan is paid off early). All of these periodic costs to borrow reduce net profits, diluting the value of the company’s equity for each shareholder.

Certainly, equity dilution is different from profits dilution. However, when talking about “dilution” generally, companies should not ignore the fact that, in finance, dilution comes in many forms.


cannabis, cbd

Latest Insights