Dilutive securities are any financial instrument that can increase the number of shares a company has outstanding. Examples include convertible bonds, options, warrants and preferred stock. The effect of dilutive securities is to reduce the price of shares and earnings attributable to each share. That’s one reason many shareholders object when a board of directors issues dilutive securities.
Dilutive Securities Explained
A dilutive security is any security or other financial instrument which can increase the number of shares that a company has outstanding. Note that while technically this can apply to private stock and preferred shares, in general usage a dilutive security refers to a financial instrument that produces new shares of publicly traded common stock. When a dilutive security is executed its effect is to reduce the value of a company’s existing shares of stock. Both price and earnings per share can dip. This is the result of a company issuing new shares of stock without increasing its earnings or any other metric which might raise the value of that stock by a corresponding amount.
This is not inevitable. For example, it’s possible that a company may time the execution of a dilutive security to correspond with increased revenue, preserving earnings per share. Or if the market had previously undervalued the stock, its price may remain relatively stable, effectively adjusting to a new price per share without actually changing the stock ticker. However, it is likely, and wise investors try to account for any existing dilutive securities when they value a company’s stock. Models such as the diluted earnings per share formula attempt to do this, capturing the potential value of a stock based on a company’s existing commitments.
The descriptive term “dilutive security” refers to any financial instrument that can lead to an increase in a company’s total outstanding shares and thereby a decrease in the company’s earnings per share. So, for example, contracts which cause the company to transfer existing shares would not count as a dilutive security. Only an instrument which changes the total per-share percentage of ownership in the company does.
Existing shareholders tend to object to dilutive securities, because these instruments can reduce the value of their stocks. As a result it is common for large or early investors to negotiate what is known as anti-dilution clauses into their contracts. This creates safeguards for the investor in the event that the company issues dilutive securities, such as low-price, priority purchase of new stock in order to make up for any change in value.
Examples of Dilutive Securities
The most common example of a dilutive security is a stock option. These instruments, when executed, can cause a company to issue new shares to the holder at a given price. They are often issued to employees as a signing or retention bonus, particularly since they are a relatively low-cost way for a company to potentially issue a significant bonus. Another common example is what is known as convertible bonds. These can be converted into common stock at a set ratio.
There also are convertible stock, which can be converted into shares of common stock at a specified ratio. They are typically sold to private investors who support a company before its initial public offering as an incentive.
Finally, stock warrants are another common example of dilutive securities. Similar to stock options, they give the holder the right to acquire new shares of stock from the company. Once executed, the company will issue new shares to the holder at the named price.
The Bottom Line
Dilutive securities are financial products that cause a company to issue new shares. They can cause share prices and earnings per share to decline, creating some resistance among existing shareholders. Among the many types of dilutive securities are convertible bonds, warrants, preferred stock and stock options. Issuing dilutive securities differs from a stock split, which also results in an increase in a company’s outstanding shares.
Tips for Investing
- Consider talking to a financial advisor about how dilutive shares can impact your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool can connect you with financial advisors in your area, within minutes. If you’re ready, get started now.
- An asset allocation that’s appropriate for your goals, age and risk tolerance can help protect you from the negative effects of dilutive securities. And unless you invest in a target date fund that automatically adjusts that asset allocation, you’ll benefit from using a free asset allocation calculator.
Photo credit: ©iStock.com/alvarez, ©iStock.com/wsfurlan, ©iStock.com/solarseven