What are fully diluted shares?
Fully diluted shares are a measure of how many shares a company has at its disposal. This measurement is used to determine how much a business is worth.
To calculate this, you need to know how many convertible securities a company has. Then, calculate how many shares would be created if these securities were converted into common stock. This is the first step in calculating the company value.
To understand what fully diluted shares are, we need to know what convertible securities are, what common stock is, and how one is converted into the other. We can then explore why fully diluted shares are important and under what circumstances they are used.
What Are Convertible Securities
To know the number of fully diluted shares a company has at its disposal, we must convert securities into common stock. But what are these convertible securities?
A convertible security is normally a preferred stock option or debt (e.g. convertible note, SAFE note, etc) that can, at a later date, be converted into another kind of ownership note.
In essence, a convertible security is what a company sometimes provides an investor in return for their capital. It is a legally binding promise that their investment can be converted into more desirable forms of shares and stocks in the future.
If a debt is given as convertible security, it is often referred especially for larger companies to as a “convertible bond” – Investopedia has a terrific article on this by Nick K. Lioudis. These bonds generate interest payments over time to the bondholder at a fixed rate. Hence why they are also referred to as a form of “fixed income debt security”.
As convertible security, these bonds can be converted into stock during milestones in the bond’s life. These milestones are agreed between the investor and the business owner. However, it is completely up to the bondholder whether they should convert the bond at that time or continue to receive interest payments.
Other stock options exist as convertible securities. A common one is the convertible preferred stock option. These are “preferred shares”, which simply means that when shareholders receive dividends from a company, those who hold preferred shares receive their dividends before common stockholders.
One of the benefits of this is that if a company enters bankruptcy, preferred shareholders receive priority in terms of payments from a company’s existing assets. There are some reasons why you would want to convert to common stock, which I will touch on at the end of this article.
While converting preferred shares into common shares can be at the behest of the shareholder, some share agreements allow a company to force the preferred shareholder to convert at a predefined date.
Another type of convertible security is employee stock, where an employee has been given a legally binding note of share ownership if they reach a certain milestone at the company. This is based on either performance or time served as an employee.
While these shares don’t “currently” exist, they are created in the future when an employee reaches the agreed conversion threshold, and should, therefore, be taken into account when calculating fully diluted shares.
What is Common Stock?
Okay, so when calculating the number of fully diluted shares that a business has at its disposal, you have to take all convertible securities (bonds, preferred shares, employee stock options, etc.) into account, imagine that they have been turned into common stock, and then that tells you how many shares a company has.
But what is common stock?
Commons stock or shares are simply another security or ownership note. The shares effectively allow the investor to own a portion of the target business. This means that they are involved in any vote to determine the board of directors and can also be involved in voting through new corporate policies.
As stated above, during a liquidation event (e.g. acquisition, IPO, etc), common stock owners do not receive priority – preferred shareholders do.
Why Convert from Preferred Shares to Common Stock?
You might be wondering why you would ever convert your preferred shares into common stock when preferred shares have some advantages. There are some very valid reasons for doing this, including:
- Being forced to via a contractual obligation.
- Wanting to receive higher returns in the long term. If a business is healthy, common stock can provide larger dividends than other stock forms.
- Common stock dividends are affected by company performance and interest rates. It’s up to the company whether they hand out a dividend based on this. Preferred stock has a fixed dividend percentage, so it doesn’t fluctuate as much. Bondholders and preferred shareholders may decide to convert at a strategically salient moment to maximize their income because a company is giving out larger dividends to common stockholders at that time.
Why Are Fully Diluted Shares Important?
To put it simply: Fully diluted share calculations are necessary to know two things:
- To know the value of a company
- To know the profitability of a company
Once the calculation has been made, taking all potential convertible options into account, you’ll know how many shares exist. After this, you can calculate the earnings per share (EPS).
The EPS of a company is essential for current and future investors and very much used with publicly traded companies. This is because it tells them how much one share will generate value or revenue. This value can then be scaled up to the entire company’s shareholdings.
Depending on the EPS, this might make an existing investor sell their shares or entice new investors to buy into the company. That’s how powerful fully diluted shares and the resulting EPS value are.
The EPS value is calculated by:
- Taking the net income of a share over its lifespan.
- From this value, subtract any preferred dividends.
- Now, calculate the weighted average for a share. To do this, take the balance of the share value at the start of its lifespan, add the current value of the share, and then divide this number by 2.
- Divide the number from step 2 by the weighted average calculated in step 3.
Not only is the EPS essential for enticing investment, but the number of fully diluted shares also helps investors understand how much of a company they really own.
Both metrics are powerful motivators in the investment world, and they also allow board members to calculate a real-world value for how their business is actually performing in terms of generating value.
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