Key Takeaways

  • Convertible preferred stock allows holders to convert shares into common stock, combining fixed income with growth potential.
  • These shares offer priority dividends and liquidation preference while providing upside if the company performs well.
  • Conversion terms vary and may include triggers like IPOs, acquisitions, or time-based events.
  • Investors must weigh the trade-off between fixed dividends and the potential dilution of equity.
  • Startups use convertible preferred stock to attract investors while retaining flexibility in capital structure.

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 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.

Common Features of Convertible Preferred Stock

Convertible preferred stock may include several built-in features that enhance investor protections and potential returns:

  • Liquidation Preference: Investors receive payout before common shareholders in a liquidation event.
  • Anti-Dilution Protection: Adjusts the conversion ratio if the company issues new shares at a lower price than the original investment (commonly in down rounds).
  • Dividend Rights: Typically paid out at a fixed rate, either cumulative (accruing if unpaid) or non-cumulative.
  • Participation Rights: In some cases, holders may receive dividends and liquidation payouts in addition to what common shareholders receive post-conversion.
  • Redemption Rights: Some agreements allow the investor to redeem the shares for cash under certain conditions.

These features can mitigate downside risks while preserving upside participation for early investors.

Tax Implications of Convertible Preferred Stock

The tax treatment of convertible preferred stock can vary depending on how and when the conversion occurs:

  • Dividends: Dividends paid on preferred shares are typically taxed as ordinary income unless they qualify for favorable capital gains rates.
  • Conversion Event: When preferred shares are converted into common stock, it is generally not a taxable event. However, if the converted shares are later sold, any capital gain will be based on the original purchase price of the preferred stock.
  • Liquidation Preference: If a liquidation event triggers a payout, investors may owe capital gains taxes on any distributions exceeding their investment basis.

Startups and investors should consult tax professionals to ensure compliance with IRS rules and optimize tax outcomes related to stock issuance and conversions.

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.

Conversion Triggers and Terms

Convertible preferred stock typically comes with specific terms that govern when and how shares can be converted into common stock. These terms are outlined in the stock’s certificate of designation or investment agreement and may include:

  • Automatic Conversion: Occurs upon a qualifying event such as an IPO at a specified share price or valuation threshold.
  • Optional Conversion: Allows the investor to decide when to convert, often based on market price or internal milestones.
  • Forced Conversion: Gives the issuing company the right to require conversion, usually once the common stock has traded above a set price for a defined period.

Understanding these conditions is critical for both issuers and investors, as they influence liquidity, control, and future capital structure.

Conversion Ratio

The conversion ratio determines how many shares of common stock an investor will receive for each share of convertible preferred stock. It is calculated by dividing the par value of the preferred stock by the conversion price. This ratio is set by the issuing company at the time of issuance. A conversion becomes profitable when the market price of the common stock exceeds the price implied by the conversion ratio.

Par Value

The par value of a preferred stock represents the nominal dollar amount that the shareholder would be entitled to receive in the event the company goes bankrupt. While it may not reflect the market value, it plays a key role in determining the conversion ratio and serves as a baseline in liquidation scenarios.

Conversion Price

The conversion price is the dollar value used to convert preferred stock into common stock. It represents the price per share at which the holder can convert their preferred shares. This price is set at the time the preferred stock is issued and directly affects the conversion ratio and potential profitability of the conversion.

Conversion Premium

The conversion premium is the difference between the current value of a convertible preferred share and the value of the common shares that would be received if the preferred share were converted. This premium affects how convertible preferred shares trade in the market. When the premium is low, the price of convertible shares closely tracks the price of the company’s common stock. Conversely, when the premium is high, their market value tends to move in line with interest rates—rising when interest rates fall and falling when they rise.

Frequently Asked Questions

1. What happens in a forced conversion scenario? In a forced conversion, the company requires convertible preferred shareholders to convert their shares into common stock, often triggered by meeting a stock price threshold over a defined period.

2. Can the conversion ratio ever change? Yes. In certain agreements, anti-dilution clauses may adjust the conversion ratio to protect investors from dilution in subsequent funding rounds.

3. Do convertible preferred shares expire? Convertible preferred stock typically does not have an expiration date but may be subject to automatic conversion upon specific triggering events such as an IPO.

4. What are the tax consequences of converting preferred shares to common? Generally, conversion is not taxable. However, capital gains tax may apply when the resulting common stock is later sold.

5. Why do startups prefer issuing convertible preferred stock? Startups favor it because it balances investor protection with the ability to defer equity dilution and align incentives with future company success.

Talk to a Lawyer

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