Hi guys!
Just joined yesterday and I’m loving the study guide so far. I ran into the first thing that I can’t wrap my head around.
So I read the entire section about convertible securities, and even reread it a couple times. I understand that convertible securities can be converted into common stock… For whatever reason I just don’t understand why they’re considered a dilutive action. Can someone break it down for me?
Thanks
Hi @stridge28! Thanks for using the Achievable forum!
Convertible securities are definitely a difficult topic to conceptualize. Let’s see if I can help you understand it a bit better by talking through a hypothetical example.
Assume ABC Company has 10 shares of stock outstanding, and you own 1 of those shares. Your one share is equivalent to 10% of the company; in plain terms, you basically own 10% of the company. Your vote is worth 10% when an item requires shareholder approval. You will obtain 10% of the dividends paid to investors if the BOD (board of directors) declares a dividend. And so on.
Let’s say ABC Company gains majority shareholder approval to issue a convertible bond. You heard it would be dilutive, but you still voted for it as issuance of a convertible bond resulted in a lower interest rate for the bond, meaning the company can borrow money for less. As a shareholder, you’re invested in the company’s success. Let’s also say they issue one convertible bond that’s convertible into 10 new shares of common stock.
A few years later, the bond is converted, resulting in 10 new shares of common stock being issued to that bondholder. This one conversion changed the outstanding shares from their original 10, to now 20. You still own 1 share of ABC Company stock, but now you own 1 of 20 outstanding shares, or 5% of the company. 5% ownership means you’ll only have control over 5% of the vote, and only receive 5% of the dividends paid.
That’s dilution. The number of shares owned didn’t change, but the power of those shares did. Conversion results in additional shares being created, and that “dilutes” the value of any shares held by investors.
I hope this helps! DM me or respond to this thread if you have additional questions.
Hi @brandonrith ,
Thanks for your reply! Let’s see if I’m understanding this correctly.
So essentially when the bond is converted to stock it’s not just simply giving the bondholder 10 already existing shares. It creates 10 new outstanding shares thus diluting the value of everyone’s shares of that company? So even though I don’t personally own any convertible bonds the value of my position of common stock could potentially be diluted simply from someone else converting their bonds? Is that right?
If this is the case, how does that work with the “right to maintain proportionate ownership”?
I think I’m struggling to grasp the concept of bonds in general since I haven’t gone through the bonds section yet. Can you tell me if I’m on the right track though?
I appreciate the help, thank you!
Yes, you’re right about the creation of new shares. The right to maintain proportionate ownership doesn’t mean dilution can’t occur. It prevents the issuer from diluting shares without shareholder approval. That’s why I highlighted gaining shareholder approval in my hypothetical. While the issuance of convertible bonds is one type of dilutive action, this can only occur with majority shareholder approval. Does that make sense?
Yes, you’re on the right track with everything! Debt securities like bonds will make more sense as you make your way through that section.
Yes that makes perfect sense. Thank you for breaking it down for me!