Dilutive securities are any financial instruments that can potentially increase the number of shares outstanding. This means that such an instrument can be converted into a share of common stock. The concept is of importance when calculating fully diluted earnings per share, where the effect of these securities can reduce earnings per share. A reduced amount of earnings per share could drive away investors, thereby lowering the price of a company's stock.
Financial instruments are usually issued with conversion features in order to make them more attractive to investors. This is particularly common for a startup business that has a strong upside potential from which investors can profit, if they own the company's stock.
The most common types of dilutive securities are:
Options. These instruments give the holder the option to acquire shares at a certain price, and within a certain date range. Options are issued to employees.
Warrants. These instruments also give the holder the option to acquire shares at a certain price, and within a certain date range. Warrants are issued to entities outside of a company.
Convertible bonds. These are debt instruments that give the holder the option to convert them into common stock.
Convertible preferred stock. These are preferred shares, usually paying a dividend, that can be converted into common stock.
The concept of dilutive securities can be more theoretical than actual, since these instruments will not be converted into common stock unless the price at which they can be purchased will generate a profit. In many cases, the strike prices are set above the market price, so they will not be exercised.