What is watered stock?
Watered-down stocks referred to shares of a company that were issued at a value far in excess of the implied value of a company’s underlying assets, usually as part of a scheme to defraud investors. The last known case of watered-down stock issuance occurred decades ago, as the structure and regulation of stock issuance evolved to put an end to the practice.
This term is thought to originate from herders who made their cattle drink copious amounts of water before taking them to market. The weight of water consumed would deceptively weigh down livestock, allowing herders to fetch higher prices.
Key points to remember
- Watered stocks are an illegal scheme to defraud investors by offering stocks at misleading prices.
- Watered shares are issued at a higher value than their actual value; it is accomplished by overestimating the book value of the business.
- Watered stock, once revealed for what it is, becomes difficult to sell, and if sold, it usually does so at a much lower price than originally obtained.
Understanding Watered Stock
The book value of assets may be overstated for a number of reasons, including inflated book values - such as a one-time artificial increase in inventory or property value – or excessive issuance of stock through a stock dividend or an employee stock option program. Perhaps not in all cases, but often in the late 19th century, company owners would make exaggerated claims about a company’s profitability or assets and knowingly sell shares of their company at a price by value which far exceeded the book value of the underlying assets, leaving investors with a loss and fraudulent owners with a gain.
They would do this by bringing goods into the business, in exchange for the inflated face value stock. This would lead to an increase in the value of the company on the balance sheet, even though, in reality, the company would hold far fewer assets than declared. It is only much later that investors will learn that they have been deceived.
Those who held watered-down stocks found it difficult to sell their shares, and if they could find buyers, the stocks were sold at prices well below the original price. If creditors seize the company’s assets, watered stockholders could be held liable for the difference between the company’s book value and its value in terms of real estate and assets. For example, if an investor paid $5,000 for shares that were only worth $2,000, they could find themselves liable for the $3,000 difference if creditors seize the company’s assets.
Daniel Drew, cattle driver and financier, is credited with introducing the term watered stock to the world of finance.
The end of watered stock
This practice essentially ended when companies were forced to issue low-par or no-par value shares, usually on the advice of lawyers aware of the risk that watered-down shares create liability for investors. Investors were wary of the promise that the face value of a stock represented the real value of the stock. Accounting guidelines have been developed so that the difference between the value of assets and a low or zero face value is accounted for as capital surplus Where premium.
In 1912, New York allowed corporations to legally issue stock without par value and to allocate incoming capital between excess capital and stated capital on the books of account, with other states following suit soon after.