What is a Simple Capital Structure?
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.
- A simple capital structure is a capital structure that contains no potentially dilutive securities.
- Companies with a simple capital structure are only required to report basic earnings per share (EPS).
- Examples of potentially dilutive securities include convertible preferred stock, convertible debt, stock options, and warrants.
Types of Capital Structure
- Simple capital structure
- Complex capital structure
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 simple capital structure are only required to report basic earnings per share. However, those 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.
Understanding Potentially Dilutive Securities
Potentially dilutive securities are securities that could potentially be converted to common stock and dilute the earnings of shareholders. Companies with potentially dilutive securities follow a complex capital structure. The following are common potentially dilutive securities:
1. Convertible preferred stock
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.
2. Convertible debt
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.
3. Stock options
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 it grants 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.
Example of Simple Capital Structure
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 owns 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 is indicative that the company owns potentially dilutive securities and, therefore, a complex capital structure.
Identifying Companies with a Simple or Complex Capital Structure
As discussed, companies with a simple capital structure are only required to report basic earnings per share. On the other hand, companies with a complex capital structure are required to report both basic and diluted earnings per share.
By looking at a company’s income statement, one can identify if it follows a simple or complex 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 follows a complex capital structure. Shown below is an excerpt of the company’s income statement:
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