A dilutive security is any type of investment security that has the potential to increase the number of common shares outstanding. In other words, itís any securities that can be turned into common stock. The idea is that if a security increases the outstanding shares it will dilute the current shareholders stake in the company as well as their owner benefits like future dividends and voting power. Unless the existing shareholders have the right to maintain their ownership when dilutive securities are converted, their stock will become slightly less valuable.
Like most investments, dilutive securities can take a few different forms. Common stock is obviously the most common dilutive security because any additional issuances of common stock will automatically raise the number of outstanding shares.
Beyond that, some other examples include convertible preferred shares, stock options, rights to buy, and convertible bonds.
Convertible preferred stock is often issued to investors who want the benefits of owning a preferred share with the security that it can be turned into a common share at any time. These shares work in many different ways, but the most common convertible preferred shares can be converted for a set amount of common shares upon demand of the shareholder.
Stock options are typically seen in executive pay packages. These are contracts that give the owner the right to purchase common stock at a given price at a given time. When stock options are exercised, the options become common shares and increase the number outstanding.
Rights to purchase stock are similar to options in that they give the owner of the right the authority to purchase new common stock.
Convertible bonds are similar to convertible preferred stock. These bonds can be converted according to their contract into common shares.
As you can see, there are many different types of securities that can affect the number of outstanding shares of common stock. There also several financial ratios like the dilutive earnings per share that track the effect of these securities.
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