Convertible Preferred Stock: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
Convertible preferred stock is a type of preferred stock that gives holders the option to convert their preferred shares into common shares after a date.5 min read
What is Convertible Preferred Stock?
Convertible preferred stock is a type of preferred stock that gives holders the option to convert their preferred shares into a fixed number of common shares after a specified date. It is a hybrid type of security that has features of both debt (from its fixed guaranteed dividend payment) and equity (from its ability to convert into common stock).
All stocks represent a portion of the ownership of a company. They can be divided into different types. Common stock is the most common, as the name suggests, followed by preferred stock.
Preferred stock can also be further divided into different types, including cumulative preferred, callable preferred, participating preferred, and convertible preferred. Preferred stock, unlike common stock, is typically given to investors in young companies, and the company and the investors negotiate the terms. Venture capitalists typically receive convertible preferred stock when they invest in a startup.
For example, say a company issues convertible preferred shares to an investor that have a par value (value at time shares were issued) of $100 each, pay a 5 percent dividend annually, and have a conversion ration of 6. The worst that investors in this issue can do is get the 5 percent dividend -- which which comes out to $5 per year for every share they own.
However, if the common stock prices are rising, the investors can do even better. They can exchange their convertible shares for common shares and get six common shares for every share of convertible preferred they own, based on the conversion ratio. A conversion ratio of 5 means they get 5 shares of common stock for every of convertible preferred, a conversion ratio of 6 means they get 6 shares, and so on.
For the investor to make money on this exchange, the common shares have to be trading at a price greater than the purchase price of a share of the preferred common stock divided by the conversion ratio. In this example, the common stock would have to be trading higher than $100/6, which equals $16.67 per share, in order for the conversion to be profitable.
Risk and Returns
There is a slightly higher risk that a company may default on preferred stocks, especially if the company has poor credit. Also, the price of preferred stock may drop when interest rates rise. On the other hand, the price may rise when interest rates fall.
Advantages to Investors of Convertible Preferred Stock
Preferred stock holders receive a fixed, guaranteed dividend payment. Common shareholders have no guarantee that they will receive dividends. However, if the earnings of a company increase, the company may choose to raise the dividends that it pays on common stock. Meanwhile, the preferred stockholders plug along, still getting the same fixed rate.
In time, the dividend rate paid on common stocks may surpass the rate paid to preferred shareholders. In that case, the ability to convert their shares to common shares is an advantage. It lets the preferred stock holders share in the company’s increased earnings.
Just as common stock dividends can rise, so can the price of common stock shares. This rise can be even more dramatic and is essentially unlimited. Here, too, holders of convertible preferred stock enjoy an advantage over holders of stock that is not convertible.
With convertible preferred stocks, investors can enjoy the bond-like stability of preferred stocks for a period of time. Then, if the company is doing well, investors in convertible preferred stocks can convert their stocks to common stocks and gain the benefit of the stock appreciation.
If the company does poorly, convertible preferred stockholders do not have to convert their shares to common stocks. They can keep their convertible stocks. Then, if the company goes bankrupt, they will be paid from whatever assets remain before common shareholders get a chance. So they have the chance to gain from a company’s success while still maintaining some protection from a company’s failure.
Disadvantages to Investors of Convertible Preferred Stock
When convertible preferred stock holders convert their stock to common stock, they get to share in the company’s growth. However, that advantage comes with disadvantages, because the investor will lose the advantages that preferred stocks have over common stocks – priority in getting paid dividends, priority in asset distributions if a company goes bankrupt, a guaranteed, fixed-rate, and generally higher dividend.
Also, before conversion, convertible preferred stock holders may receive a lower dividend rate than other preferred stock holders. This is because the convertible holders have received something of value -- their ability to convert their stocks. To compensate, the dividend rate may be lowered.
Advantage to Startups of Convertible Preferred Stock
When companies issue preferred stock, they become obligated to pay dividends for as long as the company exists. However, if a convertible preferred shareholders converts to common stock, then the company’s obligation comes to an end. This is because companies have no obligation to ever pay dividends to common stock holders.
Some agreements allow companies to force investors to convert their shares.
Disadvantage to Startups of Convertible Preferred Stock
When convertible preferred stock holders choose to convert their stocks to common stocks, the stocks they receive are newly issued. This increases the total number of common shares. Because the number of common shares increases while the value of the company remains the same, the value of existing shares goes down. In other words, the new common shares dilute the value of all the common shares, which drives down the share price.
Companies will sometimes offer to buy back the converted shares to prevent dilution.
When to Convert
Holders of convertible preferred stock have the right, but not the obligation, to convert their shares into common stock shares. Venture capitalists who hold this type of stock will typically convert on two occasions – after the company makes an initial public offering (IPO), or after the company is acquired by another company.
Frequently Asked Questions
- What is the “conversion ratio”?
The conversion ratio equals the par value of the preferred stock, divided by the conversion price. It tells you how many shares of common stock an investor receives for every share of convertible preferred stock that is converted. The company sets the conversion ratio before it issues the convertible preferred stock.
In order for the conversion to be profitable, the common stock must be trading above the share price that the ratio determines.
- What is “par value”?
The par value of a preferred stock is the dollar amount that the stock holder would be entitled to be paid if the company went bankrupt.
- What is “conversion price”?
The conversion price is the price, in dollars, for converting preferred stock into common stock.
- What is the “conversion premium”?
The conversion premium is the difference between the value of the preferred shares and the value of the common shares if the preferred shares were converted.
The conversion premium influences the price of convertible preferred shares traded on the market. The market price of convertible shares will tend to rise and fall with the price of the company’s common shares when the premium is low. When the premium is high, the convertible shares market price tends to track interest rates, rising when interest rates fall, and falling when interest rates rise.
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