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A simple capital structure is a capital structure that contains no potentially dilutive securities. In other words, a simple capital structure consists only of common stock, nonconvertible debt, and nonconvertible preferred stock.
As outlined above, a simple capital structure does not contain any securities that could potentially dilute the company’s earnings. In contrast, a complex capital structure contains securities that could potentially dilute the company’s basic earnings.
Companies with a complex capital structure are required to report both basic and diluted earnings per share. Following, we outline potentially dilutive securities that could change a simple capital structure into a complex capital structure.
Potentially dilutive securities are securities that could potentially be converted to common stock and dilute the earnings of shareholders. Companies with potentially dilutive securities have a complex capital structure. The following are common potentially dilutive securities:
Convertible preferred stock is a type of security that gives the holder the option to convert their preferred shares into a fixed number of common shares after a specified date.
For example, the holder may be entitled to convert one preferred stock into five common shares when the company goes public.
Convertible debt is a type of security that gives the holder the option to convert, at the discretion of the debtholder, existing debt to a fixed amount of common stock.
For example, the holder may own a $1,000 par value bond paying a 6% coupon rate with a conversion ratio of 20 common shares for each $1,000 par value bond.
Stock options grant employees of a company the ability to buy shares of the company at a fixed price after a specified date.
For example, the holder may hold stock options with an exercise price of $50 that vest over a three-year period.
Warrants are like stock options in that they grant an individual the ability to buy shares of the company at a fixed price. However, a major difference is that warrants are usually issued in conjunction with debt or equity securities to “sweeten” the deal while stock options are granted to employees.
For example, a company may attach five warrants to each $1,000 par value bond issued. Each warrant is convertible to 15 common shares with a strike price of $5 and an expiration date of June 1, 2025.
An analyst is looking for warrants and stock options on the company’s annual report to determine additional capital that could be raised if they were exercised. The analyst finds that the company has 500,000 stock options outstanding with a weighted average price of $5. What does it indicate about the company’s capital structure?
The 500,000-stock options outstanding are indicative that the company owns potentially dilutive securities and, therefore, has a complex capital structure.
By looking at a company’s income statement, one can identify its capital structure. For example, in Facebook’s 2018 annual report, the company reported 2018 basic earnings per share of $7.65 and 2018 diluted earnings per share of $7.57. Therefore, Facebook has a complex capital structure. Shown below is an excerpt of the company’s income statement:
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