Dilution is a central concern for biotech investors. The basic issue at hand is that developmental-stage or early commercial-stage biotechs rely heavily on dilution to raise the massive amount of capital necessary to fund their operations prior to becoming cash-flow-positive. 

So what is dilution exactly? Dilution is the issuance of new shares that results in current shareholders owning a smaller piece of the pie, so to speak. Companies issue new shares typically through either a secondary offering (aka a secondary registration) that requires shares be sold at prevailing market prices following a registration statement, or a shelf offering (aka shelf registration) that allows the company to dole out new shares when conditions are favorable to do so (such as a sudden price increase).

The word "dilute" spelled out in different colors against a wood background.

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The big difference with these two common mechanisms of issuing new equities is that secondary offerings are an immediate release of new shares at a set price, whereas shelf offerings can be executed over the course of up to two years. 

Given that dilution is part and parcel of investing in clinical- or early commercial-stage biotechs, I think it's critical for investors to understand the impact of capital raises on shareholder value from both a short- and long-term perspective. So, with this theme in mind, let's consider whether biotech investors should fear dilution, or simply shrug it off as a necessary evil.

The bad side of dilution

When companies resort to issuing new shares to raise capital, investors almost always decide to revolt right out of the gate -- causing the company's share price to dip further than it really should from a pure dilution standpoint (i.e., the share price decline should roughly reflect the magnitude of the offering).

This general trend stems from two interrelated factors. First off, the current crop of shareholders will subsequently own less of the company than they did previously, meaning that the value of each of their shares will decline as well. That's the basic and inescapable consequence of any new equity offering as described above. 

However, the bigger issue is the trust factor. The core problem is that a number of biotechs have done next to nothing to create shareholder value over their history. And instead, these companies have diluted shareholders time and again simply to pay their bills.

The small-cap immuno-oncology company Agenus (NASDAQ:AGEN) and the inhaled insulin company MannKind Corporation (NASDAQ:MNKD) are prime examples of this phenomenon. Even though both of these companies have been in existence for over two decades, these two particular biotechs have failed to bring a product to market capable of generating a significant revenue stream. As a result, these two companies have essentially been forced to wipe out their early shareholders through serial dilution.

AGEN Chart

AGEN data by YCharts.

Simply put, investors dread dilution because of the offhand chance that companies will abuse their goodwill through regular offerings like Agenus and MannKind -- regardless of the actual circumstances on the ground. As a result, secondary and shelf offerings more often than not cause panic in the shareholder community, triggering an emotionally charged decline in share price.  

But dilution can create shareholder value

Dilution isn't always a bad thing, however. The fact of life is that innovation in the biomedical field is insanely expensive. Not only do companies have to shepherd their products through the lengthy clinical trials process that can take upward of a decade, but they also need to pay sizable fees to regulators during the review process, as well as build out a sales force to market the drug post-approval. All of these steps require money, and lots of it. 

Nonalcoholic steatohepatitis (NASH) drugmakers Madrigal Pharmaceuticals (NASDAQ:MDGL) and Viking Therapeutics (NASDAQ:VKTX) serve to underscore this point. Thanks to an overwhelmingly positive midstage trial result for Madrigal's MGL-3196 -- a drug that shares the same mechanism of action as Viking's VK2809 -- shares of both companies have skyrocketed in value this year.

To get to the launching pad, however, each company had to raise its fair share of capital via secondary offerings, whereby diluting shareholders. But this money was put to good use, and it ultimately created more value for shareholders. 

MDGL Chart

MDGL data by YCharts.

Madrigal is now reportedly entertaining possible suitors, and Viking is closing in on a top-line readout of its high-value NASH candidate later this year. The good times therefore appear to be only getting started for these two developmental biotechs, and this positive turn of events wouldn't have been possible without diluting early shareholders. 

Investor takeaway

Biotech investors will undoubtedly run into a secondary offering or shelf registration at some point in their career. There is no way around it due to the time-consuming nature of bringing new medicines to market. However, I think investors can protect themselves from catastrophic declines in value by being taking a critical look at how a company actually uses its capital.

In the case of Agenus and MannKind, these two companies have repeatedly promised to create shareholder value, only to stumble and eventually resort to issuing shares at inopportune moments (when their share prices were already on the decline). Madrigal and Viking, on the other hand, have taken their newfound capital and turned it into tangible value for shareholders. The market has thus rewarded these two promising biotechs with substantially higher valuations. 

The take-home point here is that dilution can be a powerful way to create value for shareholders, but it all depends on the company and management team in question. When a company chronically fails to transform newly acquired capital into shareholder value, biotech investors have the right to be wary of future capital raises.

But that doesn't mean that investors should fear dilution in all cases, all the time, per the prevailing trend. If anything, Madrigal and Viking prove that capital raises can be a thing of beauty for shareholders.

George Budwell has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.