What is Convertible Preferred Stock?
How does it work?
What are the essential elements you should know!
In this article, we will break down the definition of Convertible Preferred Stock so you know all there is to know about it!
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Table of Contents
What Is Convertible Preferred Stock
A “convertible preferred stock” is a type of company preferred stock allowing the stockholder to convert them into common stocks.
It’s called a “convertible” stock as the stockholder has the option to “convert” them into common shares.
It’s called “preferred stock” as it allows the stockholder to benefit from a fixed and guaranteed payment of dividends.
In essence, convertible preference shares offer its holder the ability to benefit from a fixed stream of income when it’s held as preferred stock and eventually benefit from the upside offered by the company equity when converted into common shares.
For example, a company can issue convertible preferred stocks having a par value of $50, dividend of 8%, and where the holder has the option to convert them into common shares once the common shares of the company move above the conversion price of $100.
Notably, the most common reason why companies issue preferred convertible stock is for their fundraising needs.
When raising capital, the company can choose to raise funds through debt or equity.
By issuing preferred shares, the company benefits from a “hybrid security” having characteristics of debt and equity.
Preferred shares will generally not have voting rights and will have a price volatility similar to fixed-income securities.
Convertible Preferred Stock Definition
According to Investopedia, convertible preferred stocks are defined as follows:
Convertible preferred stocks are preferred shares that include an option for the holder to convert the shares into a fixed number of common shares after a predetermined date.
In other words, the holder of the convertible preferred stock will have:
- The option to convert the shares into common shares
- Can only convert the shares after a predetermined date
- Can convert the shares based on a fixed conversion ratio
Why Issue Convertible Preferred Equity
A company can issue stocks to shareholders representing a portion of the company ownership.
In this context, a company can issue common shares (representing the most common type of equity securities issued) and preferred shares (generally offering guaranteed dividends).
In fact, by offering guaranteed dividends on the preferred shares, investors may find it more attractive to invest in the company.
To make things sweeter for investors, by issuing a preferred convertible stock, the investors will not only have the ability to tap into a steady stream of income but also benefit from the growth in company valuation when converting preferred stock to common stock.
Types of Preferred Shares
There are different types of preferred shares a company may issue, such as:
- Cumulative preferred shares
- Callable preferred shares
- Participating preferred shares
- Convertible preferred shares
There are many ways a company can adjust the rights associated with the preferred shares.
For instance, the preferred shares may be redeemable at the discretion of the company, they may be mandatorily convertible into common stock, they may have different rights associated with the payment of dividends, or they may even be non-convertible preference stocks.
Advantages of Preferred Convertible Stocks
From an investor’s point of view, receiving a fixed payment of dividend is certainly an advantage.
Typically, companies are not required to pay dividends on common shares.
However, if the company issues preferred shares to stockholders entitling them to dividends, they are bound to respect the dividend payout commitments.
No matter the company’s financial situation, it must pay the investor the fixed dividend payout.
Another advantage for investors when purchasing convertible preferred shares is that the price of the preferred shares varies in a similar way as debt securities like bonds.
As such, the value of the preferred shares is less volatile than common shares but can vary depending on the market rate of interest.
From a company’s point of view, by issuing preferred shares and committing to pay dividends, they can attract more investors.
In certain cases, the trade-off in issuing preferred shares and committing to dividends is worth it when the company can tap into the capital it needs to further expand or commercialize its product.
Disadvantages of Preference Convertible Shares
From an investor’s point of view, the disadvantage of the “preferred” convertible shares is that once they choose to convert the stocks into common shares, they lose their right to their dividend payments.
As a result, an investor will need to carefully evaluate its options before converting the preferred shares into common shares.
If the company is doing well and the value of its common shares are exploding, there’s no doubt that the preferred stockholder may have a clear interest in converting the shares to common shares.
Otherwise, the preferred stockholder should keep its shares and continue earning dividends.
From the company’s point of view, issuing preferred shares with guaranteed dividends imposes a financial obligation on the company to ensure the dividends are paid (thus avoiding a breach).
Defaulting on the payment of preferred shares is not going to be well received by the stakeholders of the company.
Also, when the preferred shareholders convert their shares into common shares, the common shareholders will see their percentage ownership in the company reduced.
In other words, the conversion of the preferred shares dilutes the percentage ownership of every common stockholder.
Convertible Preferred Stock Example
Let’s look at an example of how a company may issue “convertible preferred” shares.
Let’s say a company wishes to have a venture capitalist invest in it.
The company will issue convertible preferred shares to the VC having a par value of $50 per share when they are issued.
The preferred shares are designed to provide the VC an 8% annual dividend and have a conversion ratio of 5.
In this case, the VC will be entitled to 8% dividends for so long as they hold on to the convertible preferred shares.
Now, imagine that the company does well and the overall company valuation goes up.
The VC can take advantage of the company’s increased valuation by converting its convertible preferred shares into common shares of the company where one preferred stock gives five common stocks.
On the other hand, if the company does not do well, the VC can keep its preference convertible stocks and keep earning its 8% dividends on a yearly basis.
Preferred Convertible Stocks Takeaways
So what is the definition of Convertible Preferred Stock?
Let’s look at a summary of our findings.
Convertible Preferred Stock
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