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DEFINITION of 'Common Stock Equivalent'

A common stock equivalent is a security – such as stock options, warrants, convertible bonds, preferred bonds, two-class common stock and contingent shares – that can be converted into common stock. Sometimes preferred stock can also be converted to common stock.

BREAKING DOWN 'Common Stock Equivalent'

Also called common shares or ordinary shares, common stock is what most individuals buy when they invest in a stock. It typically gives them the right to vote on corporate issues in proportion to their ownership in the company and the right to receive dividend payments. Common stock may be subdivided into class A shares and class B shares, which can have different voting and dividend rights. The other type of stock is called preferred stock, and its holders receive priority over common stockholders when dividends are paid and in the event the company liquidates.

How Common Stock Equivalents Are Converted

Common stock equivalents, depending on their nature, are typically converted or exercised when a certain exercise price has been met or exceeded on the market. The terms are typically set when the security is issued. As long as the market price has been met, the security will be on a par with common stock and can be converted without a loss.

Common stock equivalents are comparable to potentially dilute securities, which can act to dilute current shareholders ownership. A company must show in its income statement its diluted earnings per share and base earnings per share if there are different forms of stock available, which includes the securities that result from common stock equivalents.

There are a variety of ways that common stock equivalents can be introduced. For instance, employee stock option plans may be offered to workers as job incentives and augments to their salaries. Such programs allow employees to receive options or warrants, or can purchase securities at a discounted rate that they can later convert, usually after a specified vesting period. Typically, they must wait one year from when the securities are granted before they may exercise their options and convert them to common stock. There might also be stipulations that another full year must pass from the date they are exercised before the employee may then sell those securities.

Other forms of common stock equivalent can come with their own rules governing when and how they may be exchanged, such as converting bonds into shares. The stipulations may give the company more time to build up their assets through the funds used to purchase such securities before they are converted into common stock.

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