Contingent Shares

What Are Contingent Shares?

The term contingent shares refers to company stock that is issued to certain shareholders under special circumstances. They act just like regular common stock, except that companies issue them when they meet certain conditions, such as making a profit, meeting earnings expectations, or during mergers and acquisitions (M&A). When a company issues contingent shares, the ownership of existing shareholders becomes diluted.

How Contingent Shares Work

Corporate shares represent an ownership stake in the company by the holder. Private companies issue shares to founders, owners, and their management teams. Public companies offer shares to the general public on the primary and secondary markets, where a single share indicates a certain equity stake in the company. So if a company has 100 shares and one person owns 10 of them, they have a 10% ownership stake.

Shares come in many shapes and sizes. The most common are common shares, which allow shareholders to vote on corporate issues and to elect the board of directors, and preferred shares, which give shareholders priority for dividend payments over others. Then there are contingent shares.

Contingent shares are just like common shares—with one difference. They are only transferred to the recipient once certain conditions are met. These conditions 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.

They are commonly used in M&A activity. When one company acquires another, the two parties may disagree on the price to be paid. When this happens, one party can offer contingent shares to the other party to help close negotiations. Once the deal is complete, the shares can be transferred to the intended recipients. If the condition isn't met—regardless of what it is—the shares become worthless and aren't issued at all.

Special Considerations

M&A activity may not simply involve the issuance of contingent shares. They may also bring rise to certain conditional rights called contingent value rights (CVRs). These rights are often given to shareholders of companies that may be subject to buyouts or restructuring.

By issuing these rights, the company guarantees that shareholders get these benefits if the event occurs, such as an acquisition. For instance, if a buyout is realized, the CVR may pay out cash to rights holders. If the conditions tied to CVRs aren't met or fulfilled, they become worthless.

Advantages and Disadvantages of Contingent Shares

Advantages

The principal benefit of contingent shares is that they encourage certain outcomes by sweetening the pot with the reward of shares. For instance, it's in the best interests of management if the condition is that the company makes a profit before members of the team can receive the shares. Similarly, these shares can be used as a negotiating tool between parties during M&A activity.

These shares help align the interests of management and employees with those of the company's shareholders. They can ensure the interests of their agents are aligned with their own through contingent shares that vest only after certain financial or operational thresholds are reached.

Disadvantages

One of the major drawbacks of contingent shares is that they 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 decrease a company's earnings per share (EPS) because profits will be spread among a greater number of shareholders.

The real impact of potential dilution depends on the terms of contingent shares. If the shares are conditioned on substantial improvements to the company's performance, these achievements might far outweigh the dilutive effect of the additional shares being issued. But in some sense, sharing the pie with more people shouldn't be a problem as long as the company grows beforehand.

Example of Contingent Shares

As noted above, contingent shares 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 own 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 12 months following the acquisition.