DEFINITION of Contingent Shares
Contingent shares of company stock are issued only if certain conditions are met. Contingent shares are similar to stock options, warrants and other convertible instruments in that there is a level of uncertainty associated with their issue. For example, for contingent shares to be issued, the corporation must generate earnings that exceed a certain threshold. Contingent shares are also important for common stockholders since the contingent shares can dilute the ownership of existing shareholders.
BREAKING DOWN Contingent Shares
In the TARP bailout, the U.S. Treasury was granted contingent shares in certain companies. These shares were meant to offset the risk of loss for taxpayers. Under the terms of the agreement, the contingent shares vest automatically if the U.S. Treasury loses money as a result of purchasing the troubled assets.
Contingent shares as a financial security make an attractive incentive option. To entice managers while aligning their interest with shareholders, a contingent share can help motivate managers to grow a business as they would benefit from an increase in value as well.
The primary drawback to contingent shares is their dilute nature. If the contingency is triggered, thereby expanding the number of available shares, existing shareholders will see their ownership stake fall proportionally.
Example of Contingent Shares
For example, Company A acquired Company B. During the negotiation; Company A agreed to issue 20,000 common shares to the shareholders of Company B if Company B increased its earnings by 20% in the current fiscal year. The current earning of Company B is $200,000, and the current number of shares outstanding is 200,000.
As of now, the earning per share would be = (Earning/Common Shares) = ($200,000/200,000) = $1 per share.
Now, let’s say that Company B can hit the target of a 20% increase in its earning this year. That means Company A will issue 20,000 common shares as contingent shares.
As a result, the new earnings would be = ($200,000*120%) = $240,000.
And, the number of shares issues would increase to = (200,000 + 20,000) = 220,000.
Therefore, the new EPS would be = ($240,000/220,000) = $1.09 share.
However, an additional 20,000 in common shares will proportionally dilute existing shareholders before the issuance of the new [contingeny] shares.