What are contingent shares?
Conditional shares are similar to common shares. They provide an ownership stake in the company. However, they are conditional and are released to the shareholder only when certain underlying conditions are met. These conditions are variable and dependent on the agreement between the two parties.
They are most commonly used in mergers and acquisitions. If the acquiring company is not fully convinced of the profitability of the company, it can issue contingent shares. For example, Company R is acquiring Company G. In this process, the companies are not agreeable to certain terms. Even with negotiation, they cannot resolve these issues. By issuing contingent shares, Company R and Company G come to an “if-then” agreement.
How do Contingent Shares work?
Company R can set an earning target for Company G and when these targets are met, Company R will benefit the shareholders of Company G by issuing a particular number of common shares. In absolute terms, the conditions could be – Company R will issue 4,000 common shares to the shareholders of Company G if Company G can increase its earnings by 15% in the current fiscal year.
How does this benefit the shareholders of Company G?
Theoretically, the increase in earnings is offset by the increase in the number of shares. However, the terms of contingent shares, in this case, are such that there is the ultimate advantage to the shareholders. Let us assume that the current earning of Company G is ₹2,00,000. The current common shares issued by the company are 50,000.
Current Earning per Share (EPS) = (Total Earning/Common Shares)
= (₹2,00,000/50,000) = ₹4
If Company G can increase its earnings by 15%, 4,000 common shares will be issued.
New Earning = (₹2,00,000 * 115%) = ₹2,30,000
Number of shares = 50,000 + 4,000 = 54,000
New Earnings Per Share = (₹2,30,000/54,000) = ₹4.25
Thus the earning per share for shareholders of Company G increases when the contingencies are met and new shares are issued.
Importance of contingent shares
Contingent shares play an important role in mergers and acquisitions. If the party is not fully convinced of the profitability of the company, contingent shares serve as a safety net and the deal is more likely to go through. It encourages the current shareholders to be more participative and keep the company in check as they derive direct benefit from the company achieving the set targets.
In high-growth industries, companies often use contingent shares because the buyers are wary of the profitability and future performance while the sellers are confident and optimistic. The contingent shares balance these two outlooks and can be used in acquisitions successfully.
Conditional stock issuance is one of the strategies companies practice to plan for and raise funds for all sorts of contingencies. It also acts as financial protection and is an attractive way for earning incentives.
Advantages of Contingent Shares
By issuing contingent shares, a company can benefit many stakeholders and it is a strategy that ensures that all parties are satisfied in the trade. For new shareholders, companies offer contingent shares which act as a bonus and make the investment more attractive. For the managers, these shares offer additional incentives for better performance of the company. Thus, it motivates them to ensure that the contingencies are met.
This is one of the most important processes in the acquisition phase, creating a situation that benefits both the acquirer and the target company. Due to the potential for additional profits, conditional consideration can motivate the management of the acquired company to continue with them after the acquisition.