Legal Definitions - common-stock equivalent

A common-stock equivalent is a financial instrument that, while not actual common stock, can be exchanged or converted into common stock under specific conditions. Because of this inherent convertibility, these instruments are treated as if they were common stock for certain financial calculations and reporting purposes. They represent a future claim on a company's equity, impacting how potential ownership and earnings per share are viewed.

Here are some examples illustrating common-stock equivalents:

• Convertible Bonds: Imagine a growing technology company issues bonds to raise capital. These bonds come with a special feature: after three years, bondholders have the option to convert their bonds into a fixed number of the company's common shares instead of receiving their principal back in cash. Even before any conversion takes place, these convertible bonds are considered common-stock equivalents because they represent a potential future claim on the company's common stock, which could dilute existing shareholders' ownership if converted.

• Employee Stock Options: A successful startup grants its key software developers stock options as part of their compensation package. These options give the developers the right to purchase a certain number of the company's common shares at a predetermined price (the "strike price") at some point in the future. Although the developers don't own the shares yet, these stock options are common-stock equivalents because they represent a future right to acquire common stock, and their potential exercise is factored into financial analyses, such as diluted earnings per share.

• Warrants Issued with Preferred Stock: A biotechnology firm raises funds by selling preferred stock to institutional investors. To make the preferred stock offering more attractive, the firm also includes "warrants" that allow the investors to buy additional common shares at a set price within the next seven years. These warrants are separate from the preferred stock but are considered common-stock equivalents because they grant the holder the right to acquire common stock, thereby representing a potential increase in the number of outstanding common shares in the future.