Share dilution is rarely met with anything but contempt from shareholders, though there are some cases where it can be used for the good of the company and shareholders alike.

In this week's crossover episode of Industry Focus: Healthcare, Kristine Harjes talks with guest host Gaby Lapera from the Financials show about why companies might dilute their shares, for better or worse. Then, the hosts dive into a business where the dilution rules get a little strange -- business development companies, or BDCs. Find out what a BDC does, how dilution is different for this class of businesses, and how investors probably want to approach BDCs.

A full transcript follows the video.

This podcast was recorded on Nov. 16, 2016.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market everyday. It's Nov. 16. I'm your host, Kristine Harjes, and I am pleased to welcome Financials host Gaby Lapera in the studio for crossover week. Hi, Gaby!

Gaby Lapera: Hello, everyone! I'm super excited.

Harjes: It's always awesome to be able to do the show with somebody in the studio. I love you to death, Todd Campbell, but it's so nice to have somebody who you can look and gesticulate to and have right here. You can feel the energy, feel the love.

Lapera: Dude, I totally feel you. I think you and I are the only hosts that consistently have our analysts in the cloud somewhere. So this is super cool. I'm going to look at you the entire show; don't get freaked out.

Harjes: I will probably avoid eye contact.

Lapera: OK.

Harjes: Anyway, today we're going to be talking about shareholder dilution. Of course, since it is crossover week, we want to put an emphasis on our two respective sectors. We'll try to focus it with a lens on both healthcare and financials. I figure we'll start off with some basics. Gaby, do you want to kick it off and tell us about what dilution is and why it matters?

Lapera: Yes, I would love to. Dilution, much like the chemistry term, means that you are becoming less concentrated. Shareholder dilation in particular means two really important things: one, that the economic power of the share that you hold is less, and two, your voting rights are less because the share makes up less of the company. Let's back up a little bit, because I realized I just jumped straight into the conclusions of dilution and didn't actually explain what it was. When companies decide to issue more stock, they don't magically have more assets, so the stock becomes less in price because there are more of them. It's a very simple equation.

Harjes: I think of it like a pie. You have the same size pie -- you can chop it up into however many pieces, but you still have the same pie at the end of the day. I think that's why there's such a negative perception of shareholder dilution, because if you are holding on to this piece of pie that you paid good money for, you don't want to see it suddenly get smaller. But there are good reasons why companies will dilute. Some of the really common ones are, for example, to pay for an acquisition. Sometimes it's to raise money. Maybe you need that to service your debt, or something like that. Another really common reason why shares become diluted is the conversion of stock options granted to employees or board members. A bunch of companies will give their executives, or their employees in general, the option to convert these securities into common shares. And when they actually do exercise that option, it dilutes the current shareholder base.

So this can be a good thing or a bad thing. It's largely a bad thing. Most people are not pleased when they hear that they're being diluted. But it actually could be a good thing, which is kind of an interesting case. Say, for example, your company is overvalued and you know it. Which, hopefully, you bought it when they were undervalued, and now you're sitting on an overvalued company. Regardless -- say a company is overvalued, and the company goes to pay for an acquisition using stock. That's smarter than doing that using cash, because the shares are worth more than the cash value. At that point, you could be very happy to see that, because this slice of pie that you have accumulated is suddenly a bigger pie. It's cut up more ways, but the pie is bigger, so that's a good thing. But in general, it's not the best. Many times, you can perceive it as a transfer of wealth from the retail investor to the insiders, when you have the exercise of stock options. 

You also have the option of it being pretty neutral, which is kind of the same as the case when it's good, except that that would be if you're using it in an acquisition where you're paying a fair price, and the company that you own is also fairly valued. That's net-net -- your slice of the pie is smaller, but the pie is proportionately bigger, so it's pretty neutral.

Lapera: I would love a real-life example, if you have one.

Harjes: I can do that, and I'm probably going to pick a healthcare stock, if that's alright with you.

Lapera: That's totally fine.

Harjes: One recent secondary offering that was announced in the healthcare world was that of Puma Biotechnology (NASDAQ:PBYI). On Oct. 18 after the closing bell, they announced that they wanted to raise $150 million, and potentially another $22.5 million on top of that because of some technicalities with the people who underwrote the shares. They could technically have the option to buy them within 30 days, if they want. So this was an interesting situation because Puma, right now, has this one drug called Neratinib. It's a breast cancer drug. If you were listening to this show yesterday, by the way, it's an HER2-positive breast cancer drug, which is a target that I was just talking about with Vince on the Consumer Goods show yesterday. Anyway, you have this drug, and it's under FDA review right now, the decision should come out in about mid-2017.

Lapera: That means they're still testing the drug?

Harjes: That means the trails have either largely wrapped up or that they have enough that they could submit it to the FDA with what they have right now. The FDA is sitting on the information, they have the application, and they have a certain amount of time to actually accept or deny the drug the right to be marketed. So, an approval, as you likely know, would send shares of this company higher. If you think about how the mechanics of shareholder dilution and secondary offerings work, you want to wait until you have that higher share price before you go out and send more shares, because you make more money. But they don't really have enough time left with the cash that they have to wait for an actual approval. So they had to do this now. And I think it's probably a smart move. They can hit the ground running; they can get ready for the launch. But shares did sink 18%, even before the price of this secondary offering was announced. Since this announcement came out, shares have been slipping and slipping even more. Ultimately, shareholders were diluted about 15%, and the company got the money that they needed. So I think that's a fairly typical way you'll see secondary offerings and shareholder dilution in the biotech world. You have these companies that aren't making with the money with the drugs yet, because they're not approved yet, so they need to make money somehow.

Turning to the financials world, I feel like it gets a lot hairier.

Lapera: It can, definitely. You have a ton of regular type companies in the financials world, like banks and insurance companies and stuff like that, that do this what I like to call "the normal way," the way that Kristine just described. But then there's other companies. We've discussed these companies before. A great example of them is a BDC, which is a business development company. When you think about a BDC, think of them as a venture capitalist that you can buy shares of. Instead of you personally going out and saying, "I would like to invest in your pizza delivery company," you would invest in the BDC, who would then give money to the pizza delivery company. Obviously, you can't buy shares of private equity firms, because they're private equity firms. BDCs are really interesting because they're closed-end funds, which means they can't accept new investments all the time.

Harjes: What do you mean by that?

Lapera: Imagine you have a mutual fund, and you give the mutual fund $1,000 of your money. You can go to the mutual fund any time and say, "I want my $1,000 back," or, "I want to give you an extra $1,000," and the mutual fund says, "Great, totally fine, here's your $1,000 back." You can't do that with BDCs. The only way to get your money in and out of the BDC is just to buy or sell the shares that are on the exchange. That's because BDCs typically invest in the debt or equity of really small private companies -- back to this single pizza store in Washington, D.C., or a jewelry store in Idaho, or a mattress company. I don't know why, but BDCs love mattress companies. 

The problem with that is that if you have the debt of a very small company, it's really difficult to buy or sell those companies or the debt on those companies, because not a lot of people want it. So if an investor were able to just come up to the BDC and say, "Hey, I want my $1,000 back," or, in this case, maybe "I want my $100,000 back," the BDC might not have the cash on hand to give it back to them, which is why they issue shares instead. That's why BDCs have shares to begin with, as opposed to a mutual fund.

Harjes: So then, what sorts of issues do you run into if they decide they want to issue even more shares?

Lapera: This is really interesting, and this gets into how the value of BDCs are calculated. If you've invested in a mutual fund, or have heard of mutual funds, you might have heard the term "net asset value," which is super easy to calculate with mutual funds, because it's just the value of all the assets minus the liabilities that are on the balance sheets. Now, the problem with BDCs is, they get to decide how valuable their assets are.

Harjes: And that's because they're these tiny pizza/mattress/etc. companies, right? You can't just go look online to say, "How much is this mattress shop worth?"

Lapera: Exactly. They don't issue 10-Qs, they don't have any of that. Unless you happen to be wherever that mattress company is, and you can walk in and look at it and maybe talk to somebody there, it's really hard for investors to do their due diligence on what the BDCs actually own, so you have to just trust them. There are accounting principles that they follow for this, but I like to call it emotional accounting, because it's really just how the BDC feels about this business. There is math involved, but it's a little bit more ... I wish listeners could see me, my hands are making vague motions in the air.

Harjes: Her face looks highly skeptical.

Lapera: I'm so skeptical.

Harjes: The point is, it's a little bit shady, how you determine that asset value. But that's a really important metric for BDCs.

Lapera: Absolutely. The easiest way to explain BDCs is in contrast to mutual funds, which is why I keep bringing them up. If you want to buy into a mutual fund, you know exactly how much each bit of the mutual fund is, because the net asset value is calculated once a day at the end of the day, which is why you only come in and out of mutual funds once a day. But BDCs, their share price is not 100% dependent on their net asset value. You can buy BDCs at a discount, or a premium. Typically, people want to buy at a discount.

Harjes: In that way, it's kind of like a stock.

Lapera: Exactly, it's exactly like a stock. And people do take net asset value into account when buying shares. But it's an interesting thing, because where is the point where you're saying, "You're trading it too much of a discount to your actual net asset value, and it makes me really nervous"?

Harjes: Right. At that point, is the market missing something, or is the company misleading you? I can see how that's a shaky gray area. Bringing that back around to this whole shareholder dilution thing, where exactly does that come into play here? What are the steps involved, the considerations?

Lapera: OK, let's throw in one more complicated thing. This requires a lot of definitions to even get to the point here, so bear with us -- thank you, listeners! BDCs are technically not allowed to issue shares below their net asset value. So if their net asset value is $10, they can't issue shares for $8.

Harjes: Which is kind of fascinating. If you think about it, go back to the example of Puma Biotechnology, I'm pretty sure they were trading at $52 the day that it was announced that they were going to offer more shares. They're not going to offer more shares at a higher price than that, because who's going to buy them? You can buy them on the market for $52. So you naturally have this ceiling for stocks, where if you're going to issue more shares, it has to be below know that current share price. 

Lapera: Right. Companies can just decide to do that. BDCs cannot. If they would like to do that, they need to ask their shareholders to let them dilute their stock. So they have proxies every year. It's interesting, because if BDCs are struggling, they can't just automatically lean on share issuance to prop themselves up. But there's this caveat -- BDCs frequently ask their shareholders, every year pretty routinely, "Hey, can we issue stocks below net asset value?"

Harjes: "Like, hypothetically, in the future, if we want to, will you let us?"

Lapera: Yes.

Harjes: That's a pretty long leash.

Lapera: Exactly. And Investors will frequently say yes, which I hate. 

Harjes: Why is that?

Lapera: Why say yes?

Harjes: Can you see the rationale there at all?

Lapera: No. I really can't. I can't justify it. If you're one of these people who vote yes, please write in to me at industryfocus@fool.com and let me know why you say yes. I really want to know. Because I would never say yes in a million years.

Harjes: Even if you totally trusted this BDC, it had been great to you in the past, you thought the net asset value was very trustworthy, all that?

Lapera: Yeah, I would never say yes. Partially because BDCs are a really complicated beast, which is really something that I say every time we talk about BDCs, and there's a lot of room for mismanagement to occur in BDCs, not just with share dilution but with the way that management occurs, external vs. internal management, fee structures, the accounting processes we talked about earlier, there's just a lot of ways for people to mess up in BDCs, so it's one of those things -- why give you the temptation when it's not necessary?

Harjes: Right, I can see that. That leads me to the last thing I wanted to talk about with you today. I know BDCs have a pretty heavy presence of activist investors, and I have to assume that's because of all these things they were just saying, where there's this opportunity for mismanagement.

Lapera: Yeah, absolutely. But interestingly, activist investors are actually more attracted to BDCs that cannot issue more shares, because it's a lot easier for them to take control of them --

Harjes: You mean, people voted no?

Lapera: Yeah, people voted no. Typically, if people vote no, that means there's something wrong with the BDC, because it takes a lot for shareholders to vote no, for whatever reason. So if they're voting no, it's because there's already something bad going on.

Harjes: So that's an indication of a lack of trust?

Lapera: Yeah, on the shareholders' part. And there's plenty of companies that never actually use this -- that the shareholders vote yes and the company's never do it, they just ask every year just because, because they're fine raising capital in other ways. But if you think about it, if a BDC has been told, "No, you can't issue any more shares," it suddenly becomes a lot more easy -- and they're already in trouble, so no one really wants to buy more shares of them, so they can't finance themselves, they can't issue themselves more shares below net asset value -- it becomes a lot easier for an activist investor to start buying up shares and be able to take a stake in that company that allows them to force that company to do what they want.

Harjes: So what is it that they want them to do at that point? How do you take this and turn it around?

Lapera: It totally depends on the activist investor. I think some have better intentions than others.

Harjes: Do you think the primary goal there is to get that yes vote the next time it comes around?

Lapera: No. For most activist investors, they want to retain control of the company.

Harjes: And that's why they go for the ones that already voted no, that makes sense.

Lapera: Most frequently, activist investors want to change management structures or fee structures, in order, generally, to make it more profitable for shareholders. But every once in a while, they want to devalue the company to make it easier for someone else to buy.

Harjes: Interesting. Have they been successful, on the whole?

Lapera: Yeah. BDCs are prime targets for activist investors. Especially because they're so complicated, and not a lot of people really 100% understand what's going on with them. But they are really high-yielding investment vehicles because they, much like real estate investment trusts, are required to pay out 90% of their taxable income as dividends. Because they're investing in high-risk, tiny businesses, the margin on their loans, or the debt they have, is a lot higher. So, they have the potential to yield super high returns.

Harjes: Given everything that you've told us today about BDCs, is there a single one that you would consider investing in?

Lapera: I hate BDCs.

Harjes: OK, that's a no.

Lapera: As a personal investor, I think they're fascinating as something to study. But no, I would never buy a BDC. I know that makes me biased. I'm acknowledging my bias.

Harjes: I think that's OK. Look, for example, at Warren Buffett. He says he doesn't want to invest in stocks he doesn't understand. That eliminates a lot. For example, he's not going to invest in a biotech. I like to think you can understand biotech even without a science background. That's what we're here for at Industry Focus: Healthcare. But, he's ruling out an entire chunk of companies, just because he doesn't think it's worthwhile to even bother trying to pick out the gold in a pile of dirt. That's not a real phrase, but I'm making it one. I feel like that's the same way with BDCs. Maybe there is a gem out there, but in general, it's a category that we're not too big fans of.

Lapera: Yeah. Do you like them?

Harjes: Not from what I've heard, no. With the shadiness, I would be intimidated to even try to pick apart the real net asset value.

Lapera: Yeah. I'm just waiting for a BDC PR specialist to reach out to me today and be like, "Let us change your mind about BDCs. We'd really love to give you an interview." And I'll probably ignore it or crotchetily -- which is not a word, by the way -- cantankerously say, "No!" But nicer, because it's never polite to be mean.

Harjes: With that nice lesson of the day, I think I'm going to close out the show. Thank you, Gaby, so much for being here and explaining to us this very complex topic of BDCs, and offering some thoughts about shareholder dilution. Before we totally sign off, I want to tell everybody that there's a race going on this Sunday in Alexandria, Va. If you live somewhere in the neighborhood of Fool HQ, you should absolutely consider signing up. It's called the Run for Shelter. It benefits The Carpenter's Shelter, which is a great local organization that The Motley Fool works with to fight homelessness. Chris Hill and Alison Southwick, some names that you'll recognize if you listen to our whole suite of podcasts, will be there. I'll be there. Many, many other Fools will be there. And we hope to see some of you there. Don't hesitate to come up and say hi. If you do run the race, there's a 5K, 10K, and 1 mile.

Lapera: I won't be there.

Harjes: Gaby, unfortunately missed the sign-ups because of her lovely trip to Asia that I'm sure you guys have heard plenty about. But, she'll be there in spirit. Anywho, you can check out all of our past episodes of Industry Focus, and all of The Motley Fool's podcasts at our Podcast Center, which is at podcasts.fool.com. While you're there, you can also check out our flagship newsletter service, which is called Motley Fool Stock Advisor. This Friday, the new issue of Stock Advisor comes out, and they're going to have two new stock recommendations from David and Tom Gardner, who are the co-founders of our company, and some really phenomenal stock pickers. You can check out the recommendations by going to the Podcast Center, scroll all the way to the bottom. Again, that is podcast.fool.com.

As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. For Gaby Lapera -- thank you very much for being here -- I'm Kristine Harjes. Thanks for listening, guys, and Fool on!

Gaby Lapera has no position in any stocks mentioned. Kristine Harjes has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.