Overhang

Definition

Overhang is a financial term used primarily in corporate finance to refer to shares or securities that have been issued but not yet exercised or converted into common stock. It typically involves stock options offered to employees or convertible bonds. The overhang can dilute the value of common stock shares and can also be seen as a burden or liability because it represents potential future dilution of equity.

Phonetic

The phonetic spelling of the word “Overhang” is /ˈoʊvərˌhæŋ/.

Key Takeaways

Three Main Takeaways About Overhang

Definition: Overhang is a term often used in finance and property sectors. In finance, it refers to any number of shares previously authorized but remains unissued and can still be bought by investors. In property sector, overhang describes a part of a building, such as a balcony or roof, that hangs over the property boundary.
Impact: An overhang can affect a company’s stock price or a real estate property’s value. A high equity overhang can dilute the value of existing shares, thereby negatively impacting a company’s stock price. Architectural overhangs, on the other hand, can contribute to a property’s visual appeal, energy efficiency but might also cause disputes if it goes beyond boundaries.
Management: Companies need to manage their equity overhang to minimize dilution and maintain investor confidence. Property owners or designers must ensure that any architectural overhang complies with relevant local regulations regarding property boundaries.

Importance

In the business/finance sector, the term ‘overhang’ plays a crucial role as it refers to the potential dilution of earnings per share (EPS) or value per share for existing shareholders due to the issuance of new shares or the conversion of convertible securities. When a company has a significant overhang, it might depress the stock’s price as investors anticipate potential dilution of their share value. Overhang can also discourage potential takeover attempts, as acquirers would have to purchase more shares to gain control of the company. Therefore, understanding overhang is critical for investors in making decisions about buying, selling, or holding a company’s stock.

Explanation

Overhang in the corporate finance context pertains to a situation wherein a company has issued options and warrants for its shares, which if exercised, can dilute the value of existing shareholders’ shares. The primary purpose of this concept is to incentivize and retain key employees or to generate additional funds for the company. Maintaining a reasonable level of stock overhang allows companies to use it as a strategic tool. When companies offer stock options to employees, it not only provides an additional form of compensation but also encourages employees to work towards improving the company’s stock price, aligning their interests with those of other shareholders.From an investment perspective, overhang is used to evaluate potential risks associated with future dilution of shares. An excessive overhang could mean a forthcoming dilution of share value, discouraging potential investors and lowering share prices due to the perception of over-supply. Thus, firms and investors use the overhang ratio (number of stock options outstanding divided by total shares outstanding) to evaluate the level of overhang and the associated risk. Therefore, while overhang can be an effective mechanism for aligning employee and shareholder interests, it must be used judiciously to prevent negative impacts on the company’s share price and investor confidence.

Examples

1. Apple Inc.:During the early 2000s, Apple Inc. dealt with a large options overhang due to its generous stock options given to employees, including CEO, Steve Jobs. These options causes a significant dilution of shares in the market. However, as the company grow massively successful, the options became incredibly valuable, making Apple employees very wealthy.2. Amazon.com Inc.:In 2000, Amazon had a significant overhang problem. The company had granted stock options to its employees that accounted for nearly 15% of the total shares. This was well above the average overhang level of 5-6% which is typically considered acceptable in the corporate world. Investors were worried about the implications of this excess overhang, particularly the potential earnings dilution.3. Oil Industry in the Mid-2010s:Overhang can also apply in commodity markets. For example, in the mid-2010s, an overhang of crude oil occurred due to overproduction from countries like the United States, Saudi Arabia, and Russia. The supply significantly outweighed demand, leading to an glut (or “overhang”) of oil. This overhang led to a sharp drop in oil prices globally.

Frequently Asked Questions(FAQ)

What does the term Overhang mean in finance and business?

Overhang is a financial term referring to the potentially dilutive effect of stock options, restricted stock, or any other types of equity grants still available for future grants to employees. It represents the number of these securities divided by the total quantity of outstanding company shares.

How is overhang calculated?

Overhang is typically calculated using the following formula: (Shares in Stock Option Plans + Unissued Option Shares) / Total Outstanding Stocks.

Does a higher overhang ratio indicate good or bad for the company?

As a general rule, a high overhang ratio implies that a large number of shares are held for option or equity plans. This can lead to dilution of existing shareholders’ value, which is often viewed negatively. However, these plans also serve to attract and retain employees, so it’s not inherently bad.

What is the effect of overhang on a company’s stock price?

The potential overhang can exert downward pressure on a company’s share price due to the potential for dilution of shares. Investors might be less willing to invest in a company with a high overhang ratio.

Is a lower overhang ratio always preferable?

Not necessarily. While a low overhang ratio reduces potential share dilution, it might also indicate a company is not adequately incentivizing employees with equity grants. This can lead to challenges in attracting or retaining talent.

What is a typical overhang percentage for public companies?

It varies significantly by industry and specific company circumstances. However, many would argue that an overhang ratio ranging from 10% to 20% is generally considered acceptable.

What is the difference between option overhang and equity overhang?

Option overhang refers specifically to stock options that are either outstanding or available for future grants, whereas equity overhang broadly includes any type of equity grants including restricted stocks, performance shares, and other forms of potential dilution.

Can overhang be reduced?

Yes, the use of overhang can be reduced by decreasing the number of shares available for future grants, allowing outstanding options to expire, or by increasing the total number of outstanding shares.

Related Finance Terms

Dilution
Equity Compensation
Stock options
Shareholder Rights Plan
Employee Stock Ownership Plan (ESOP)

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