Updated July 18, 2023
Definition of Contingent Shares
Contingent shares situational based shares which are issued by companies provided they meet certain conditions and contingent shares are similar to what we call as stock options, warrants or convertible bonds where there is a magnitude of uncertainty assigned with their issue i.e. when a company wants to issue continency shares it must first and foremost have an income which crosses a set benchmark.
Explanation of Contingent Shares
As discussed above we see contingent shares can only be issued by companies when certain criteria or conditions are met by the companies. They play a very crucial role for the common shareholders as issuing of contingent shares decreases the ownership ratio of existing shareholders. Thus, a lot of new shareholders gets a place to the new ownership distribution of the stock. Contingent shares when looked as financial security is a real good avenue to make an incentive over the investment. The only cons of contingent shares are that they are a lot dilute in nature which means suppose a contingency scenario arises where the number of available shares of a company is expanded, existing shareholders will see their ownership of holding the shares decrease proportionately to the issue of new contingent shares.
Example of Contingent Shares
We will assume here a live case scenario which is very commonly practiced across the globe and can be widely seen. This is a typical case of acquisition where company X has acquired company Y. When the contract of the acquisition were laid in it was decided that company X will be issuing some 50,000 common shares to the investors who are holding shares in company Y provided that company Y shows a 15% rise in its earning capacity in the present financial year, which technically means company Y has to increase its earnings capacity by 15% to get the advantage of common shares.
At the present company, Y has an earning capacity of $300,000. The current number of shares outstanding which are in existence for company Y stands at 300,000. Thus, from this, we can arrive at a conclusion that the EPS generated by company Y is $300,000/300000 = $1/share. Now, if company Y success in achieving the 15% rise in earning capacity as the target set by company X then company X will have to go for issuing 50,000 for common shares for company Y. Thus, now new earning for company Y is like $300,000*120% = $360,000 and the new number of shares will be 300,000+50,000 = 350,000. This eventually means the new EPS for company Y will now stand at $360,000/350,000 = $1.03/share
Impact of Contingent Shares on EPS
As discussed in the above example we can clearly see the issue of contingent shares will always have an impact to the EPS or earning per shares of a company. Generally, it drives the EPS to a higher number but then again this cannot be considered as a thumb rule as it may vary from situation to situation. Specially in cases of acquisition, the acquiring company will issues new shares for the shareholders of the company getting acquired, and in this way the number of shares of the acquired company increases. When calculating the EPS now the acquired company will no long use the old outstanding share count but use the new share count which includes the addition of newly inducted shares from the acquiring company.
Thus, this will also get a new EPS number which eventually will be higher than the old one. The EPS number to go high a mandatory condition is that the acquired company should show a potential rise in the earning capacity on getting new shares issues by the acquirer company. Thus, when both the components of the EPS ratio increase, we can eventually see a rise in the earning per share number too.
Importance of Contingent Shares
The several importance of contingent shares are as follows:
- The Contingent share can drive the EPS of a company which is a number that every shareholder will look for before investing.
- Contingent shares make way for many common shareholders to the existing shareholding pattern and thus one can gain access to owning the stock.
- The contingent share issue is one of the strategies which is practiced by corporates to plan any kind of contingency or raise fund for the same.
- They also act as financial security which makes it an attractive option for earning incentives.
Advantages
The advantages of contingent shares are as follows:
- It helps companies plan their contingencies or raise fund for the same taking into consideration of specific conditions.
- It is one of the most important process followed during the acquisition phase which creates a win-win situation for both the acquirer and the target company.
- The Contingent share create a new base of shareholders where common shareholders now gain access to the ownership of the stock.
- It can also help the managers gain motivation to grow business as they would benefit from the increased valuation as well.
- Contingent shares issued for shareholders during acquisition is a bonus and act as an attractive incentive.
Disadvantages
The disadvantages of contingent shares are as follows:
- Contingent shares are highly dilute in nature.
- Existing shareholders, because of the issue of contingent shares see a dip in the shareholding pattern where due to access of new entrants the percentage holding of existing shareholders comes down.
- Contingent shares issued during acquisition will always have a forced target or pressure on the acquired company or the target company to show a significant rise in the earning capacity to get the advantage of additional shares.
- It always has a condition applied and is always released based on some specific causes. Thus, one should be very careful about the cause and condition.
Conclusion
As discussed above we could see how contingent shares play a key role among corporates and what are the advantages and disadvantages of its issue for both corporates and investors. It also helps the companies to meet up their sudden contingencies and raise funds for the same where new common shareholders are also introduced to the company by means of the additional share issue.
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