Dilutive Securities
Dilutive securities are financial instruments that a company offers to investors that have the potential to be converted into regular securities which are capable increasing the number of issued shares.
Dilutive securities are financial instruments that a company offers to investors that have the potential to be converted into regular securities. These include Convertible bonds, Stock options, Warrants, Convertible preferred shares & Contingent shares, among others.
These are financial instruments capable of increasing the number of issued shares, which may reduce the company's shareholding percentage by current shareholders.
Consider this:
- A company offers convertible bonds to investors. If the holder exercises his conversion right, they will exchange their bonds for a certain number of shares, depending on the conversion ratio established by the company.
- The employees or executives can purchase company shares at a predetermined price if they have stock options. When exercised, the stock options can increase the total shares outstanding. This increase in shares can dilute the ownership percentage of existing shareholders.
So, how do they work?
- Let's imagine a company that initially has 100 shares. A new investor buys 10 shares, giving them a 10% shareholding, i.e., a stake in the company. So far, so good.
- The company also has options or warrants available, which allow the purchase of an additional 20 shares at a lower price. If these options or warrants are exercised, and all 20 shares are bought, the total number of outstanding shares increases to 120.
- Even though the new investor didn't sell any of their shares, their ownership percentage fell to around 8.3%. This occurs because the total number of shares has increased, which diluted the investor's ownership stake in the company.
- This dilution of ownership can happen with any financial instrument that can increase the number of outstanding shares. It may have a bearing on the price of existing shares, given that company profits and assets are distributed over greater shares.
- Dilutive securities are financial instruments that have the potential to be converted into regular securities, thereby increasing the number of outstanding shares and potentially diluting the ownership percentage of existing shareholders.
- The impact on share price can be both positive and negative. It can fund growth opportunities, attract new investors, and enhance the company's value.
- The convertible securities may affect the companies' financial statements, e.g., decreasing earnings per share, increasing price-to-earnings ratio, declining return of capital, and affecting balance sheets by increased liabilities and leverage.
- When looking at a company's profitability per share, dilution earnings per share EPS is a more sensible measure that considers the dilution of convertible securities and gives a comprehensive view of the firm's profitability.
- Investors can potentially profit from the upside of the company's success, and employees can receive incentives through stock options or other equity compensation.
Types of Dilutive Securities
Let's delve into a discussion on common types of dilutive securities and their implications. First, we'll explore instruments like stock options, convertible bonds, and warrants, shedding light on them.
1. Stock options
A stock option is an agreement whereby the holder may, without compulsion, purchase a set number of company shares at a specified price within a certain time limit.
Options are typically granted to employees as part of their compensation package or to attract and retain key talent.
As soon as the option has been exercised, shares may be purchased and sold at a determined price below or above the current market price. These are a type of security that increases the number of outstanding shares of the company if exercised.
2. Convertible bonds
Convertible bonds can be converted into specific shares of the company's stock. So it's like having a flexible bond that can transform into stock if the investor chooses to convert it if they want.
They offer the potential for investors to participate in the upside of the company's stock price while providing the security of fixed income. When the holder exercises the conversion option, the bond is exchanged for the predetermined number of common shares.
3. Warrants
This security allows the holder to purchase or sell an underlying asset at a predetermined price within a specific period. Warrants are a type of financial instrument used in the stock market.
4. Convertible preferred stock
Convertible preferred shares are preferred stock that can be converted into a predetermined number of common shares of the issuer's stock.
In the event of insolvency or liquidation, they offer a single dividend payment and priority over ordinary shares. When the holder exercises the conversion option, the preferred shares are exchanged for the predetermined number of common shares.
5. Stock appreciation rights
It is a type of compensation where recipients have the right to obtain cash payments due to an increase in the company's stock price over a defined period. These can be either converted into shares or redeemed in the form of cash.
6. Contingent shares
To pay the company's shareholders an annual dividend, contingent shares are a type of equity security. They are only issued if certain conditions or contingencies are met.
7. Restricted stock units (RSUs)
Restricted Stock Units are a form of equity compensation where the company promises to issue shares or cash payments to its employees on future dates.
8. Convertible debt securities
Convertible debt securities are a particular type of bond or loan that can convert into an actual number of shares of that issuer's capital later. The conversion takes into account the established conditions and arrangements agreed in advance.
9. Convertible notes
Convertible notes are debt securities that can be converted into equity at a predetermined price or conversion rate. Early-stage companies typically use them to raise funds from investors who are willing to lend money for the right to convert their debt into ownership shares.
Convertible notes offer the advantage of providing a source of capital without diluting the ownership of existing shareholders while also providing potential upside to investors if the company performs well.
10. Participating preferred stock
Participating preferred stock gives the holder the right to receive dividend payments before common stockholders and the ability to share in any remaining profits alongside common stockholders.
Participating preferred stock is a hybrid security that combines preferred and common stock features.
11. Exchangeable debt securities
A type of debt that can be exchanged for equity in another company is an exchangeable debt security. They allow investors to convert their debt into ownership shares in a different company, often at a premium price.
12. Contingent convertible bonds (CoCos)
A type of debt security that can be converted into equity in the case of specific events, such as the issuer's capital ratio falling below certain threshold values, is a contingent convertible bond, also called a CoCo bond.
They are designed to help prevent financial institutions from becoming insolvent by automatically converting into equity during financial stress.
13. Equity units
These are two or more securities, typically a common stock and a warrant, sold as a single package. They offer investors the possibility of capital appreciation and purchasing additional shares at a specified price.
The types mentioned above are some of the common types of dilutive securities; however, many other dilutive securities are not mentioned above.
Dilutive Securities Impact on Share Price: Positive Impacts
Various factors affect the impact of Dilutive Securities on Share Price, similar to those affecting the Dilution of Shares. However, the impact can be either positive or negative.
The positive impacts are:
1. Funding Growth Opportunities
Companies can use dilutive securities to raise funds for growth opportunities such as acquisitions or research and development projects. This allows the company to invest in areas that might lead to higher earnings in the future, which leads to an increase in share price.
For instance:
1. One example of a company using such convertible securities for an acquisition is when Facebook used a combination of cash and dilutive securities to acquire WhatsApp in 2014.
This can drive revenues and profits, ultimately increasing the company's overall value. As a result, the share price may experience a subsequent rise.
2. Another example is Amazon's issuance of convertible bonds in 2020 to fund its expansion plans. With the funds, the company had strategic plans to acquire innovative technologies and broaden its operations, encompassing the construction of new warehouses and data centers.
3. This expansion would also allow Amazon to increase its production capacity, reduce delivery times, and increase revenue potential, positively impacting its stock price.
Companies can also issue convertible securities to fund expansion into new markets or to increase production capacity.
2. Attracting New Investors
Companies can issue such securities at a price higher than the current market price, which can attract new investors who see the potential for the company to grow in the future. This can lead to increased demand for the company's shares and a rise in the share price.
For example, Tesla issued $1.8 billion of convertible bonds in 2014. The bonds were sold at a premium of 42.5% above the market price of Tesla's stock, which helped attract new investors and raise additional capital for the company's expansion plans.
Such securities, which can be diluted, can also be used to attract strategic investors who can bring valuable expertise or resources to the company. This can enhance the company's growth prospects and lead to a rise in the share price.
An example is Uber, which sold a $3.5 billion stake in the company to Saudi Arabia's Public Investment Fund by issuing convertible notes.
This investment helped Uber expand its operations in the Middle East and strengthen its position in the ride-sharing market, which increased the company's value and share price.
Dilutive Securities Impact on Share Price: Negative Impacts
On the other hand, the negative impacts are:
1. Oversupply of Shares
Suppose a company issues many potentially convertible securities, such as convertible bonds or stock options. In that case, it can result in an oversupply of shares in the market, which can drive down the share price.
For example, In 2019, WeWork filed for an IPO and revealed that it had issued more than 100 million stock options to its employees, resulting in an oversupply of shares. As a result, the IPO ultimately failed, and WeWork's valuation plummeted.
Also, Tesla issued $2 billion worth of new shares in February 2020, diluting existing shareholders' ownership and leading to a decline in share price.
2. Conversion Price Below Market Price
If the conversion price of a convertible bond is set below the market price of the company's shares, it may lead to an increase in the number of shares outstanding, which can result in a decline in the share price.
For Example, In 2017, shares of Chinese conglomerate HNA Group plummeted after it issued $3 billion in bonds that could be converted into shares at a price that was below the market price.
Also, in 2020, shares of Indian telecom company Vodafone Idea dropped after it issued convertible bonds priced at a significant discount to the market price.
Diluted Earnings Per Share (EPS)
Diluted Earnings Per Share (EPS) is a conservative measure that factors in the potential dilution of convertible securities, offering a more comprehensive view of a company's profitability on a per-share basis.
The formula to calculate it is:
Diluted EPS = (Net income – Preferred dividends) / (Weighted Average Common Shares Outstanding + Potential Common Share Outstanding (Dilutive Securities))
The components of the formula are explained in detail below:
1. Net Income
Net income is used as the numerator to calculate the earnings available to common shareholders per share.
After deducting all costs, taxes, and preferred dividends, net profits are the overall profit or revenue made by a company during any particular period. The revenue available to ordinary shareholders is represented here.
2. Preferred Dividends
Preferred shares are a type of equity security, typically treated as an ordinary dividend to its shareholders and usually paid at a higher rate than common shares.
These are subtracted from net income before calculating the earnings per share available to common shareholders because preferred shareholders are entitled to more of the company's profit than ordinary shareholders, so they have to make a dividend payment before receiving any dividends.
3. Weighted Average Common Shares Outstanding
Weighted average common shares outstanding is a calculation used in the EPS (earnings per share) formula to determine the average number of shares of a company's common stock that were outstanding during a given period.
The weighted average common shares outstanding calculation is used in the denominator of the EPS formula to determine the number of shares to which earnings per share should be attributed. This is because the number of shares outstanding can change over time.
4. Potential Common Share Outstanding (Dilutive Security)
Potential common shares outstanding refers to the maximum number of common shares that could be outstanding at any given point in time, taking into account all possible sources of dilution.
So, how is Diluted EPS different from Basic EPS?
Basic EPS is calculated by dividing the company's net income by its total number of outstanding shares. Diluted EPS is a more conservative measure of a company's earnings per share, as it considers the potential dilution of shares from convertible securities.
Diluted EPS is calculated by adding the impact of potential common shares to the company's net income and then dividing by the total number of outstanding shares, including any additional shares that could be created from the potentially dilutive securities.
Investors consider both Basic EPS and Diluted EPS when evaluating a company's financial performance. However, while Basic EPS provides a basic measure of a company's profitability, Diluted EPS provides a more accurate picture of a company's EPS, considering the dilution effect.
Advantages of Dilutive Securities
Dilutive Securities offer various benefits and advantages to companies, investors, employees, customers, and communities. The following are some of the pros of such securities, which can be converted or diluted to different stakeholders.
1. Advantages to Companies
These financial instruments offer businesses the opportunity to raise capital, enhance their financial flexibility, reduce borrowing expenses, and allocate funds toward expansion prospects.
Issuing these potentially convertible securities can also increase the liquidity and valuation of their stock.
2. Advantages to Investors
These securities offer investors the potential for upside and increased liquidity. In addition, convertible bonds and stock options can provide opportunities to profit from the company's success.
3. Advantages to Employees
Securities, such as stock options, can incentivize employees. When a company's stock price increases, it may increase employee satisfaction, motivation, and the potential for additional compensation.
4. Advantages to Customers
These potentially convertible securities indirectly benefit customers as well.
Companies have the financial means to invest in growth opportunities, create new products and services or improve the quality and attractiveness of their offering when raising capital through such securities. In addition, this investment can lead to improved customer satisfaction and loyalty.
Increased research and development investment can lead to new, more innovative products that will improve the customer's choice.
Similarly, investments in customer service and experience can enhance the overall satisfaction of customers, fostering long-term relationships.
5. Advantages to Communities
By making it possible for companies to invest in local infrastructure, create employment, and contribute to economic growth, they can contribute to the community.
Improvements to living standards, increased tax revenues, and additional benefits can positively impact the community, benefiting its members in various ways. In addition, companies that issue these securities may also be more likely to engage in socially responsible activities which can further benefit communities.
Disadvantages of Dilutive Securities
Every coin has two sides, and while these convertible securities offer advantages to various stakeholders, they also come with certain disadvantages. The following are the cons of securities that can be converted or diluted to various stakeholders.
1. Disadvantages to Companies
Issuing such securities might result in the dilution of current shareholders' holdings and a decline in their voting rights and equity value. In addition, it may indicate the existence of financial difficulties for a company which could affect its share price.
Moreover, more than dilution securities may be required to achieve the required levels of financing if the stock price fails to meet expectations. This would lead to additional funding difficulties.
2. Disadvantages to Investors
With possible stock price reductions and a decrease in the value of existing shares, these securities can lead to more share issuances.
Moreover, a higher level of risk associated with market uncertainty and the success of company growth plans may also be faced by investors. For example, convertible bonds may be subject to interest rate risk and the potential for the underlying stock price to decline.
3. Disadvantages to Employees
They might need to provide adequate compensation or incentives, and the dilution of ownership can reduce the value of equity-based compensation plans.
4. Disadvantages to Customers
If a company's growth plan fails to succeed, there may be no immediate impact on customers. Still, it could lead to reduced investment in product development, marketing, and other customer focus initiatives, resulting in weaker quality products.
5. Disadvantages to Communities
Companies that focus too heavily on issuing dilutive securities to fund growth may need to pay more attention to other important priorities, such as investing in sustainable growth initiatives, paying fair wages, and contributing to the community.
For example, this could result in reduced employment opportunities, lower tax revenue, and weaker economic well-being within the Community.
Dilutive Securities FAQ
Issuing dilutive securities increases the company's liabilities and shareholders' equity. The cash received from selling these securities is recorded as a liability (e.g., as common stock or preferred stock).
Simultaneously, shareholders' equity increases, reflecting the new ownership claims created by the issuance.
Dilutive securities can reduce the ownership percentage of existing shareholders. The total number of outstanding shares increases when new shares are issued through such convertible securities.
As a result, existing shareholders' ownership stake in the company becomes proportionally smaller, potentially diluting their control and earnings per share.
Diluted EPS can be negative in certain circumstances. It occurs when the inclusion of potentially dilutive security(ies) leads to a larger reduction in earnings than the increase in the number of shares outstanding.
This can happen when the exercise or conversion of dilutive security(ies) significantly increases the number of shares while the earnings remain low or negative.
Negative diluted EPS indicates a potential dilution that adversely affects existing shareholders by reducing the earnings per share.
The difference between outstanding and diluted shares lies in the potential impact of dilutive security(ies) on the number of shares.
An outstanding share is the overall amount of shares held in a company by its shareholders, whether they are issuing or holding stock. No additional shares that might be created due to the exercise or conversion of diluent securities are included in these shares.
By contrast, the impact of dilution securities such as equity options, convertible bonds, and warrants should be considered when calculating diluted shares.
Diluted shares represent the total number of shares that would be outstanding if all dilutive security(ies) were converted or exercised.
By considering the potential increase in the number of shares, diluted shares reflect a more comprehensive picture of a company's capital structure and potential future dilution.
The share price can drop after dilution, although not always guaranteed. When a company issues additional shares through a dilutive event, such as a stock offering or the exercise of convertible securities, the total number of shares increases.
With more shares available in the market, the ownership of existing shareholders gets diluted, meaning their percentage ownership in the company decreases. That dilution may lead to a perception that each share's value is decreasing, which could affect its price.
Whether stocks recover after dilution depends on several factors, including the circumstances surrounding the dilution, the overall market conditions, and the company's performance and prospects.
Strong financial performance, positive market sentiment, effective capital allocation, and clear communication about the dilutive event's reasons and benefits can contribute to the stock price recovery.
Dilution can impact existing shareholders long-term, so it is crucial to carefully assess the specific circumstances and the company's prospects before concluding a potential stock recovery.
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