Stock and equity plans are the formal plans by which companies release a certain amount of share-based compensation -- usually in the form of common stock and warrants -- to be used as incentive for employees. A company may authorize the issuance of a certain number of shares and then distribute the shares to individual employees through their pension or profit-sharing plans or even as a signing bonus. The additional equity dilutes the ownership of existing common stockholders. The exact amount of dilution that occurs is referred to as the burn rate.
Estimating Burn Rate
Burn rate is generally calculated by dividing the total number of equity awards granted in a given year by the number of common shares outstanding. You can calculate gross and net burn rates, the difference between the two being that gross burn rates exclude any canceled or forfeited shares from the calculation. When you compare burn rates published by third-party sources, such as activist investors, check the footnotes to see exactly how they were calculated. Sometimes it is appropriate to use average common shares as the denominator if the number of shares outstanding has changed substantially during the fiscal year.
Burn Rate's Significance
Dilution has a negative effect on the value being generated to existing shareholders. If a company's burn rate is consistently higher than that of its peers, this implies poor corporate governance. Common shares are valued based on multiples of earnings per share. As new shares are issued, the company's earnings per share decline.
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