Definition and explanation
Dilutive securities are financial instruments issued by companies that can be potentially converted into common stock in future. If converted, these instruments increase the quantum of outstanding shares of common stock and dilute (i.e., reduce) the earnings per share (EPS) of issuing company. Typical examples of dilutive securities include convertible preferred stock, convertible bonds, warrants, stock options and other securities issued with conversion privilege. Since dilutive securities can possibly increase the issuer’s outstanding common shares, they trigger the need for computing a diluted earnings per share (DEPS) in addition to basic EPS number.
Securities with conversion features attached to them help newly incorporated businesses in achieving their initial fund raising targets because such securities are generally capable of attracting more investors.
Types of dilutive securities
The four usual types of dilutive securities are listed below:
- Convertible bonds: Convertible bonds are corporate issued debt privileged with the feature of being converted into other corporate securities, like common stock, within specific time. Read more
- Convertible preferred stock: Convertible preferred stock is a kind of corporate issued preferred stock that the holder can convert into a fixed number of shares of common stock. Read more
- Stock warrants: Stock warrants are a type of corporate issued certificates which entitle the holders to buy the shares of common stock at a certain price and within a specified period. Read more
- Stock options: Stock options are options given by companies to their key employees to buy common shares at a certain price.
Dilution decreases company’s EPS as well as devalues stockholders’ overall equity stake and thus naturally faces a resistance from existing stockholders.
The conversion rights that most of the dilution mechanisms provide to holders of dilutive securities are not easy to exercise. The price at which these rights or options can be exercised (i.e., strike prices) are often set higher than the market prices and the holders will not opt for conversion unless it results in a profit for them.
Due to above reasons, the concept of dilution is not as practical as it looks at first glance.