Protection against the dilution effect in capital increases – LeQuid, Spain
Contributions from shareholders make up the company’s equity, which acts as a guarantee to creditors, as well as financing assets. Throughout a company’s life, a large number of situations may recommend carrying out a capital increase.
- Types of capital increase.
1.1. Purpose
– Maintenance of legal minimum capital.
– Increase of own funds.
– Offsetting losses.
– Process of merger by takeover where the absorbing company expands and issues new shares to the shareholders of the absorbed entity.
1.2. How it is carried out
– Increasing shares’ face value, keeping the number of shares constant.
– Keeping the face value of the shares constant, increasing the number of shares.
– Increasing both the face value and the number of shares.
– Exchanging old shares for new shares.
1.3. Means of contribution
– Offsetting credits with company creditors.
– Charges to company reserves or profits.
– Converting bonds into shares.
– Making non-monetary contributions: goods and/or rights, including third-party credits.
– Making monetary contributions.
1.4. By valuation
– Same-price increase: price is the share’s face value.
– Increase with issue premium or above original price: the price is face value plus issue premium (issue under par being prohibited).
– Increase by means of free or released shares: the increase is charged to reserves, giving shareholders new shares free of charge.
- Potential problem: dilution effect
The increase may give rise to negative consequences for the partners or shareholders that do not or cannot participate to a sufficient extent. We have to bear in mind that each share’s value is determined by the ratio of net equity to number of shares:
Share value = Net equity / Number of shares
2.1. Dilution of economic rights
Increasing the number of shares in circulation, maintaining the same equity, gives rise to a reduction in the value of old shares, known as the dilution effect. The profits saved or withheld (the reserves) now have to be distributed among more shareholders.
This may take place in two differentiated cases:
– When the shares are issued at face value while their issue price is lower than real market price. Since after the increase there is a larger number of shares in the company, the value of old shares drops, which leads to the corresponding reduction of partners’ economic rights.
– When the company assigns the shares freely (without receiving anything in exchange) as each share corresponds to a smaller proportion of results. This happens when partners are given shares instead of being paid dividends (“scrip dividend”) issuing these liberated (free) or partially liberated shares, in which case the shareholder must make payment for a part of the increase that is not covered with reserves on the balance sheet. The value of the company is diluted as every time this practice is carried out, the number of shares is greater and, consequently, each one is worth less.
2.2. Dilution of political rights.
When a capital increase is carried out (and to a greater extent if it is carried out without an issue premium) and the minority partner does not or cannot participate, they are in danger of a considerable reduction in their participation in the company’s equity, and their participation becoming, on occasions, minuscule. This is the case because each share is a vote and following the increase the percentage of votes held by this shareholder who does not participate in the increase is reduced.
- Ways to avoid the dilution effect
3.1. Subscription right
An increase in the number of shares is not always negative for the company, provided old shareholders’ participation in equity is respected through preferential subscription rights. These consist of marketable securities whose price will vary according to the value of the old shares on the market. If there are a large number of investors interested, the value of subscription rights increases; otherwise, it falls.
A subscription right will be given for each share so that securities can be subscribed up to a proportion that allows them to keep holding the same previous percentage of participation in equity. With this right, partners decide whether or not to participate in the increase. In the first case, partners will subscribe the new shares that correspond to them according to the percentage of equity they hold. In the second case, they can sell the subscription rights on the secondary market, receiving the market value at the time of sale.
They can also partially participate in the increase by subscribing a part and selling the rest at quoted price .
3.2. Other ways of avoiding dilution
This effect will not occur either if the company is able to invest the money received in something that generates a greater level of profitability than the percentage that the increase represents over the pre-existing capital.
Furthermore, in the event that the share is issued at the same time, a way to avoid the effect is by requiring an issue premium so that shareholders also pay for company reserves, of which they also become owners. This way, the dilution effect is less intense.
3.3. Introducing enhanced majority in the articles of association
The best way of avoiding the dilution effect is, without any doubt, formalising a partners’ agreement, establishing the specific cases and restricting capital increases, conditioning them to accrediting their necessity, establishing calculation and intended business use. It is also a good idea for this agreement to include when to resort to external financing (loan, renting, leasing…).
The Capital Companies Act establishes a majority for approving a capital increase or reduction of a vote in favour of more than half the equity (art. 199).
The way to protect minority partners is by the articles of association establishing a percentage greater than as laid down by law (without reaching unanimity) for approving a capital increase, that is, introducing a statutory enhanced majority. Apart from percentage, it is a good idea for articles of association to stipulate the need for a favourable vote of a minimum number of partners (“head count”).
The aim is that majority necessary to approve the increase is greater than the majority partners’ votes, thus requiring the minority partners to make it a valid agreement.