What are Contingent Shares?
Contingent shares are those shares that can be issued if some specific conditions or milestones related to the issue of contingent shares are met by the issuer of the shares; one such condition can be earnings of the corporation which is required to exceed the targeted thresholds for the issuance of contingent shares.
In layman’s term, contingent shares are shares issued in contingent times.
Let’s look at the proposed merger details of Harmony Merger Corp with NextDecade LLC. One of the merger details is that Harmony will issue NextDecade shareholders approximately 97.87 million shares of Harmony common stock at closing, with up to 19.57 million additional contingent shares issued to NextDecade upon achievement of certain milestones.
How to Interpret Contingent Shares?
- As the name suggests, contingent shares are different. They’re common shares issued under certain circumstances, or we can say when certain conditions are met. For example, if Company A acquires Company B, Company A will agree to issue contingent shares if Company B reaches a certain earning target.
- But why this sort of settlement/agreement is required? Let us take the previous example to expand upon our explanation.
- Company A decides to acquire Company B. As a result, Company A and Company A come into contingent issuance agreement. This contingent issuance agreement is the result of a negotiation between Company A and Company B.
- While negotiating, both parties find that their terms are not in unison. And no amount of further negotiation can settle the dissonance. At this stage, both of these parties decide to come under an “if-then” terms of how one party will treat another.
- Now let’s come back to Company A & Company B. Let’s say that they have signed a contingent issuance agreement. As per the agreement, if Company B earns a certain amount, Company A will benefit the shareholders of Company B by issuing a set number of common shares. These shares are called contingent shares.
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Contingent Shares Example
Let’s take a practical example to illustrate contingent shares. It will help us understand how the whole thing happens.
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.
Effect of Issuance of Contingent Shares
- As a result of issuing such shares, there is one significant effect on the earnings per share (EPS) of the company.
- When “if and then” terms work, acquiring company issues new shares for the shareholders of the acquired company. As a result, now, the number of shares of the acquired companies increases.
- And to calculate the new earnings per share, we will use the new number of outstanding shares. As a result, we get a new EPS, which is more than the previous EPS (that may be different on different occasions).
Contingent Shares Issuance Agreement
Do you remember that we talked about contingent shares issuance agreement while explaining the concept of contingent shares? Now, let’s understand this before we go on to the other related concepts.
Contingent shares issuance agreement would be signed in the case of merger and acquisition. In merger/acquisition, the acquirer company promises to issue new common shares for the acquired company if certain conditions are attained.
Contingent shares issuance agreement generally based on two main factors –
- First, it’s the time period. In the agreement, the time is appropriately mentioned.
- Second, the primary condition which needs to be attained is either achievement of a certain earning level or the attainment of a specific market price level.
Both of these parties must agree to these two factors. And that will result in the additional issuance of shares if the condition/s is met.
Below is a contingent share issuance arrangement excerpt from RealResource Residential LLC. Here there two types of issuances –
- a $10,000 face value 12% Series A Senior Unsecured Promissory NotePromissory NoteA promissory note is defined as a debt instrument in which the issuer of the note promises to pay a specified amount to a party on a particular date. convertible into Common shares at $0.5 per share
- one detachable Common stock Purchase warrant to purchase 10,000 shares with an exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. of $0.50 per share expiring December 9, 2020.
Now let us at an example, where the pre-defined conditions were not met, and the contingent shares were not delivered.
Below is an excerpt from India Globalization Capital Inc. They completed the acquisition of 51% of the outstanding share capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side. of Golden Gate Electronics in May 2014. The terms of the agreement also included 1,004,094 shares as contingent on the electronics business meeting annual thresholds for revenue and profit through the fiscal year ending March 31, 2017
|average outstanding shares|
. In this case, the contingent issuable shares were not delivered because the acquired company was unable to meet the targets.
The impact of contingent shares on EPS (diluted EPS)
Now the question is when we should include contingent shares as outstanding in diluted EPS.
Diluted EPS FormulaDiluted EPS FormulaDiluted EPS is a financial ratio to check the quality of the Earnings per Share after taking into account the exercise of Convertible Securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc. = (Net Income – Preference Dividend) / (Shares Outstanding + Dilutive Shares + Contingent Shares).
As from the formula above, contingent shares would be added to the number of outstanding shares, which will be resulting in a diluted EPS.
Please note that Contingent issuable shares are used only when the conditions are met.
We take an example to illustrate this.
Let’s say that Company X went to merge with Company Y in the year 2015. The terms of the merger were set like this –
if Company Y’s market price of the common share exceeds $80 per share during the year 2015 or currently over $80 per share, then Company X will issue 50,000 additional shares for the shareholders of Company Y in the year 2016.
- It is seen that the market price of Company Y has already exceeded the set $80 per share in the year 2014;
- In 2014, Company Y’s market price of common shares was $100 per share on average.
- The net income is assumed to be $800,000, $700,000, & $900,000 for the year 2014, 2015, & 2016 respectively.
- And the average outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet. in 2014, 2015, & 2016 were 100,000, 150,000, & 125,000 respectively.
The question is, in this situation, how Diluted EPSDiluted EPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. would be calculated? And when the contingent shares would be added to the outstanding shares of Company X?
Let’s try to understand this situation from the beginning.
The term was that if Company Y exceeds $80 per share as the market price of the common share during the year 2015 or currently, then Company X will issue 50,000 additional shares in the year 2016.
But as Company Y has already exceeded the goal of $80 per share as the market price in the year 2014. And the market price of common shares of Company Y in the year 2014 was $100 per share. Should we include contingent shares in the year 2014?
Was the condition met in 2014? The answer is YES. We should include conditional issuable shares whenever the goal is met.
So, here’s what the EPS would be = (Net Income / Outstanding shares + Contingent Shares) = ($800,000 / 100,000 + 50,000) = $5.33 per share. It is diluted EPS for 2014.
Contingent Shares Video
In the final analysis
Know that contingent shares are not always issued. If two parties disagree on terms of mergers/acquisition, then only the contingent shares are issues (that is also if the set conditions are met like pre-determined market price or net income during a certain period).
I hope this has added value. Good luck!