Convertible loans and options intimidate many people, but they’re less complex than they seem. In the context of company share counts, they have a dilutive effect. This is due to the standard Earnings per Share (EPS) metric, which is net income divided by total shares. If there are convertible loans and other options that could become shares, then they would impact the EPS metric. Companies have an obligation to report this to investors.
In this article, I will (1) summarize why options are important to EPS, (2) explain two keywords, (3) show how convertible loans are calculated to impact Filly Diluted Shares Outstanding, and (4) show how employee stock options are calculated to impact Filly Diluted Shares Outstanding (FDSO). We’ll use examples in an Excel sheet that you can download.
Why Convertible Loans and Stock Options are Important
Public companies have an obligation to report Earnings per Share (EPS) on their annual accounts. The simple calculation is [Net Income] divided by [Total Shares Outstanding], but this figure is seldom representative of reality.
What if the company has agreed to accept debt financing, and the lender can convert its debt receivable into stock? Moreover, what if the company provides stock options to employees that can be converted into shares?
Respectively, these items are known as convertible loan options and employee stock options, and they constitute potential outstanding shares for the calculation of EPS.
Altogether, the number of (1) normal outstanding common stock, (2) convertible debt that may convert, and (3) employee stock options that may convert are known as the Fully Diluted Shares Outstanding (FDSO). We use the term “diluted” because, should the options be exercised, they would catalyze the issuance of new stock and dilute the value of all current shareholders’ stock.
But how can we estimate the number of options that lenders and employees will decide to convert? After all, they are called options for a reason. We’ll show an example below, but first we need some context.
If-Converted Method
The fact of the matter is that we do not know with certainty which options will be executed, so our calculation of EPS will be rough. The reason for this conundrum is time.
When converting an option would provide less equity value than the option, we know with certainty that the holder will not convert. However, when conversion would provide more equity value to the holder than the current option, he/she may still not convert. Why? The holder may believe the value of the option will increase even more over time.
There are two ways to handle this dynamic in our calculation of FDSO:
- First, we can read the financial statement commentary from the company to see if they provide estimations for the number of options likely to convert. Many companies use historical data to establish said rate of conversion, but this information is often insufficient.
- Second, we can assume that all options for which conversion would bring more equity value than the current option value will convert. This is known as the If-Converted method, and it is the golden standard. Most companies use it, and so will we in this article.
“In the Money”
When the equity value of the option is higher than its current value, we say that it is “in the money.” This term is worth remembering. It is not just used in the calculation of Fully Diluted Outstanding Shares. “In the money” is common financial jargon that applies to the whole financial world, including options trading in the secondary market.
That’s enough jargon — let’s look at the options.
Convertible Loan Options
A convertible loan, more generally known as convertible debt, is an option right a company provides to a lender in exchange for low-interest debt. Since conversion would translate to equity that has huge upsides, the loan carries less risk for the lender. Convertible loans, thus, benefit both the company and the lender.
Imagine that a wholesale watch company called BatchWatch needs financing in the amount of $100,000. BatchWatch is a startup, and banks consider it has too much risk of failure to reimburse a loan. Since the only benefit to the bank is interest on the loan, it’s not worth it.
However, BatchWatch has truly innovative technology, and Partners Global Bank believes it can succeed. Partners Global would like to provide a loan to BatchWatch with the option of later converting that loan into shares in the case BatchWatch succeeds.
Partners Global thus agrees to provide in convertible loans with the following conditions:
- $100,000 principle
- 0.5% annual interest rate
- Company shares: 100,000
- Value per share: $5
- Valuation Cap: $1,000,000
- Discount: 20%
- Conversion Price: the lower of the valuation of discount at the time of conversion
Easy enough — the loan has a principle value of $100k and earns 0.042% (0.5% / 12) per month in interest based on a standard loan structure. Currently BatchWatch has a valuation of $500,000. Let’s break down the other three items: conversion price, valuation cap, and discount.
Conversion Price
In short, the conversion price is the value that converting a loan option to equity would provide. For example, the convertible loan holder may be able to convert the principle value of $100,000 to shares at a conversion price of $7.
The conversion price can be “in the money” or not. For example, if a company’s share value is $8 and the conversion price is $7, then the conversion price is “in the money” because the option holder will earn $1 in equity value upon execution. However, if the conversion price is $6, then it is not “in the money” because execution would result in a loss of $1 value.
But how is conversion price established? It’s negotiated in the terms of the convertible loan and based on valuation cap, discount, or both.
Valuation Cap
A Valuation Cap is one way of calculating the conversion price. It works by establishing the highest valuation at which the loan can be converted to shares.
If the value of the company exceeds the valuation cap, then the conversion price is “in the money” because the option holder can convert the remaining principle balance of the loan into the equivalent number of shares at the valuation cap, which results in more ownership of the company.
Using our example, we established a valuation cap of $1,000,000. Assuming Batch Watch has not paid down any of the principle loan amount, this means the option will generate 10% ownership ($100,000 / $1,000,000) at most. But if the value of the company has increased to $1,500,000, then the option holder’s 10% stake equals $150,000 — a net gain of $50,000 (in the money).
Another way to calculate the amount is per share, which is the industry standard since some loans only convert partially. Imagine again that BatchWatch has 100,000 shares valued at $5 per share when the options contract is drafted. Partners Global Bank issues a $100,000 convertible loan. The current rate at which the option can be converted is $5 per share. If converted, the lone would provide 20,000 shares ($100,000 loan / $5), or a 20% stake in the company. There’s no value here, since the option converts to the share at its going price.
However, imagine BatchWatch increases in value to $1,500,000 with a share value of $15 ($1,500,000 valuation / 100,000 shares). Because of the valuation cap of $1,000,000, the option holder can convert at a share rate of $10 ($15 * valuation cap / valuation). Assuming it converts the entire loan, it forgoes the $100,000 debt in exchange for 10,000 shares ($100,000 loan / $10 per share). Those 10,000 shares are worth $150,000 (10,000 * $15) — a net gain of $50,000 (in the money).
In other words, the conversion price is $10 using the valuation cap method.
Discount
Another way to calculate the conversion price is with a discount to the current value of the share. The discount rate is determined via negotiation in the convertible loan agreement. In many cases, it’s 20%.
Imagine again that the option holder contributes $100,000 in convertible loans to Batch Watch, which has 100,000 stock outstanding and a $5 per share value. As shown above, converting would provide 20% ownership ($100,000 / $5).
BatchWatch then increases in value to $1,500,000, with 100,000 shares values at $15 each. With the discount methodology, the option holder can discount the per share value by 20% according to the agreement, which means the per share rate for conversion is $12 ($15 * (1-20%)). This means the option holder can convert the loan for 8334 shares ($100,000 / $12). Those shares are worth 125,000 (8334 * $15) — a net gain of $25,000.
In other words, the conversion price is $12 using the discount method.
Valuation Cap vs Discount Visualized in Capitalization Tables
In our example, we saw that given the increase in value of the stock price to $15, the valuation cap provided a higher return on investment than the discount for Partners Global.
In many convertible loan agreements, the lender negotiates to have both valuation cap and discount. However, some companies negotiate to exclude one or the other.
Why? Depending on the estimated growth potential of the firm, the company may believe the discount or valuation cap will better preserve equity for the current and future shareholders.
Simply, valuation cap provides a lower conversion price, and thus a higher ROI for the option holder, when [valuation cap] / [valuation] < [1 – discount rate].
For example, imagine that when BatchWatch has grown to its $1,500,000 valuation, venture capitalists would like to enter in the equity pool and contribute $300,000. Partners Global exercises its option with a valuation cap. The following structure results:
Download the Excel Here
In short, each share is valued at $15, and the VC’s $300,000 divided by $15 is 20,000. On other hand, Partners Global has a valuation cap, making each share worth $10 ($15 * $1,000,000 / $1,500,000). Their converted loan of $100k thus procures 10,000 shares ($100,000 / $10).
Alternatively, Partners Global’s result with a discount would have been the following:
The share rate for the VC remains $15, so nothing changes for them in the discount scenario. However, the share rate for Partners Global becomes $15 * (1-0.2), or $12. Partners Global, thus, converts to 8,333 shares ($100,000 / $12).
From these two scenarios, we see that the value cap is preferable to the convertible option holder, but the discount is better for the company. However, had the company valuation at Series A been much lower, it’s possible that a fixed discount rate would generate a lower conversion price than the valuation cap.
How do we know in general whether the valuation cap or discount provides a lower conversion price? In short, valuation cap provides a lower conversion price if [valuation cap] / [valuation] < [1 – discount rate].
Valuation cap provides a lower conversion price when [valuation cap] / [valuation] < [1 – discount rate].
Uneven Distribution of Liquidation Rights
We have seen that convertible option holders get to purchase shares for a price that’s lower than direct equity contributors, but that’s not the only advantage they have.
In many cases, the shares issued to VC’s at the Series A round come with liquidation preference rights. Though these don’t have a monetary value, we can assign them a numeric value in the form of [integer] [x], such as 1x. Since VCs and convertible option holders get the same shares, the option holder also gets a “discount” on these preference rights.
Dilution from Convertible Loans
As you can see in the cap tables, if a convertible loan’s conversion price is less than the current price of the stock then its conversion would dilute the other shareholder’s value. When it is exercised, it does dilute the other shares.
On the basis of the “If-Converted” methodology, this means we must consider that any “in the money” convertible loans will be executed and add them to the total outstanding shares. In this way, they decrease the value of Earnings per Share (EPS).
Employee Stock Options
The second diluting option is stock options. The key difference between stock options and convertible loans is that stock options are a kind remuneration to employees — they do not involve cash inflow to the company up front, only upon conversion. Convertible loans, on the other hand, provide cash receipts to the company up front.
Stock options allow employees to purchase a fixed number of stock at a set price, called the strike price. These options usually involve a waiting period, called a vesting period, at which different tranches of the stock can be purchased. In addition, though these vesting periods can be accumulated, there is a maximum exercise period.
For example, Batch Watch may provide employees the following stock option:
- Number of shares: 100
- Strike price: $25
- Vesting periods: 25% over four years
- Maximum duration: 10 years
- Accumulation: yes
- Kept upon leaving the company: no
In a sentence, employees can purchase 25 shares after the first year for $25 each, 25 shares after the second year for $25 each, 25 shares for $25 after the third year each, and 25 shares for $25 each after the fourth year. Employees are not obligated to exercise each portions of 25 shares as they vest, but they cannot exercise them after 10 years. Moreover, they lose the option when they leave Batch Watch.
Treasury Method
When we estimate the dilutive power of employee stock options, the most common method is called the Treasury Method. Just like convertible loans, employee stock options (ESO) are only considered to be dilutive when they are “in the money” — that is, when the conversion price (strike price) is less than the current value of the stock after dilution.
For example, let’s imagine Amazon offers stock to its employees. There are 600 employees with stock options, and they’re separated in three tranches. The first tranche has 380 vested shares outstanding, the second 460, and the third 920. Their respective strike prices are $55, $35, and $25.
Assumption of Stock Repurchase
With the treasury method, we assume that all of the money that the company receives from the exercise of “in the money” employee stock options will be used to immediately repurchase stock, so as to limit the impact of dilution on current shareholders.
Here’s a table outlining the scenario:
As you can see, Tranche 1 is not “in the money” because its strike price is higher than the current stock price. Exercising the option would mean buying the stock for more than one could in the open market. The other two tranches, however, are in the money. The treasury method thus assumes that they will all exercise the option, and the company will use those proceeds to immediately repurchase stock.
For example, the Tranche 2 shares exercised will lead to 460 new shares at a rate of $35. This provides the company with $16,100 that it immediately uses to buy back 322 stock ($16,100 / $50). The result is that there are 138 net new shares for that tranche (460 – 322). The same process applies to Tranche 3.
In the end, 598 new shares enter the market, and they are each worth 0.09% of the total value, vs 0.2% before. This is the impact of dilution from exercised Employee Stock Options.
Conclusion
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