Why Higher Dilution Limits?

September 28, 2020

Share dilution happens when a company issues additional shares, reducing the proportion of a shareholder’s current ownership.

The issue of new stock can be seen as a positive sign when, for example, it is used to raise money for expansion, to invest in competition or to introduce new products. On the other hand, existing shareholders might see it as a negative impact on both their voting power and their diluted earnings per share.

Many companies make their shares available to employees through share option schemes; which in turn would align employees’ interest to those of the company. The majority of Long-Term Incentive Plans (LTIP) and some Short-Term Incentive Plans (STIP) rely on share options which have become a common method of remuneration for Executive Directors. Under shares option schemes, employees are granted the right (but not the obligation) to buy a specified number of shares at a future date, providing they meet specific performance objectives. Businesses might be concerned on how this dilution affects the team, as each time options are granted, the proportion of equity that each shareholder may eventually receive is reduced.

A common question is ultimately what is the optimal percentage of share capital available for executive remuneration?

In order to answer this, research has been conducted analysing companies listed on the AIM market this year, from January 2020. These companies are split across a wide range of industries and market sectors. The majority were in Exploration and Production sector (35%) and in Financial Services sector (30%).

There is no formal limit in respect of dilution for AIM companies, although it can be noticed from the chart below that the median dilution limit of all companies analysed is 10%. The highest limit reported by companies was 20%, and 8.5% was the lowest.

Is the dilution limit related to annual revenue or cash reserves?
In case of low annual revenues or cash reserves, share option schemes would be a good way to reward executives if there is little cash available for salary increases or bonuses.

The chart above shows correlations between dilution limits and revenues. The higher dilution limits are found in companies which have comparatively low annual revenues. Similarly, the chart below shows correlation between dilution limits and cash reserves.

It is important to be mindful of the potential impact of dilution, because this might affect shareholders’ control and voting rights. However, in terms of value, shareholders are more likely to approve share option grants if they can see that the value of their diluted holdings after options have been exercised is greater than it would have been had the option scheme not been adopted. Therefore, an essential element in the design of share option schemes is the selection of the performance conditions which must be fulfilled before options may be exercised. In conclusion, shareholders can be influenced by internal factors and specific commercial reasons in their willingness to approve higher percentages.

For further information contact Elisa Cobetto.

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