What Are Contingent Shares?

The term "contingent shares" refers to shares issued to one or more shareholders provided that certain conditions are met. They are conceptually similar to instruments such as stock options, warrants, or convertible preferred shares.

Contingent shares are often used in mergers and acquisitions. When one company acquires another, the two parties may disagree on the price to be paid. In these situations, one party can offer contingent shares to the other party to help close negotiations. Whether the contingent shares are ultimately issued would depend on whether the underlying terms have been met.

Key Takeaways

  • Contingent shares are shares that vest subject to specified conditions.
  • They are often used to incentivize management and employees to work in the interests of shareholders.
  • Although they can be dilutive to existing shareholders, they might still create positive shareholder value on a net basis.

How Contingent Shares Work

Contingent shares are similar to common shares, in that they provide an ownership stake in a corporation or other legal entity. However, they are released to the recipient only when certain conditions have been met. These conditions can vary depending on the context. Common examples include the achievement of specified revenue targets or operational milestones, such as the release of a new product under development.

Contingent shares also help to align the interests of management and employees with those of shareholders. By offering contingent shares that vest only after certain financial or operational thresholds are reached, shareholders can help ensure the interests of their agents are aligned with their own. In this sense, contingent shares fill the same fundamental role as stock options and other forms of non-cash compensation.

The principal drawback, on the other hand, is contingent shares can dilute the ownership stake of existing shareholders. When contingent shares are released, they increase the total number of shares outstanding, thus decreasing the ownership percentage of all other shareholders. From a dividend and profitability perspective, contingent shares will decrease a company's earnings per share because profits will be spread among a greater number of shareholders.

In practice, the real impact of potential dilution will depend on how carefully the terms of contingent shares are structured. If the contingent shares are conditioned on substantial improvements to the company's performance, then those achievements might far outweigh the dilutive effect of the additional shares being issued. In colloquial terms, it may be beneficial to share the pie with more people, provided its total size has grown sufficiently beforehand.

Real World Example of Contingent Shares

One benefit of contingent shares is they can help resolve disagreements between negotiating parties. This is often the case in merger transactions, where the acquiring party will frequently disagree with the acquisition target in regard to its fair value

Suppose you are the owner of XYZ Partners, a private equity firm that is negotiating the purchase of ABC Manufacturing for $5 million. Emma, the owner of ABC Manufacturing, insists the firm's profits are on track to increase by 20% over the following year. Accordingly, she claims the purchase price proposed by XYZ should increase by 20% to $6 million.

To help bridge the divide between yourself and the seller, you offer Emma $1 million worth of contingent shares in the post-acquisition company, conditional on the company's profits increasing by at least 20% within the twelve months following the acquisition.