Convertible Preferred Stock and Example

What Is Convertible Preferred Stock?

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. Most convertible preferred stock is exchanged at the request of the shareholder, but sometimes there is a provision that allows the company, or issuer, to force the conversion. The value of a convertible preferred stock is ultimately based on the performance of the common stock.

Understanding Convertible Preferred Stock

Corporations use convertible preferred stock to raise capital. They are especially favored by early-stage companies as a financing medium.

Companies can typically raise capital in two ways: debt or equity. Debt must be paid back regardless of the firm's financial situation, but is generally less costly to the firm after taking into account tax incentives. Equity gives up ownership but does not need to be paid back. Both forms of financing have their advantages and disadvantages. Preferred shares fall somewhere in between debt and equity on the risk scale, as they incorporate features of both.

Equity provides shareholders with an ownership stake that in turn gives them voting rights and a say in how the company is run. However, equity holders have little claim on assets if the company falters and eventually liquidates. This is because debt holders and preferred stockholders have priority in terms of claims on the company's assets, with common shareholders only paid out from any residual assets. Preferred stock is a hybrid security that gives the shareholder a fixed dividend and a claim on assets if the company liquidates. In exchange, preferred shareholders don't have voting rights like common shareholders do.

Preferred and common stock will trade at different prices due to their structural differences. Preferred stocks aren't as volatile and resemble a fixed income security. There are many different types of preferred securities, including cumulative preferred, callable preferred, participating preferred, and convertibles. Convertible preferred stock provides investors with an option to participate in common stock price appreciation.

Preferred shareholders receive an almost guaranteed dividend. However, dividends for preferred shareholders do not grow at the same rate as they do for common shareholders. In bad times, preferred shareholders are covered, but in good times, they do not benefit from increased dividends or share price. This is the trade-off. Convertible preferred stock provides a solution to this problem. In exchange for a typically lower dividend (compared to non-convertible preferred shares), convertible preferred stock gives shareholders the ability to participate in share price appreciation.

Convertible Preferred Stock Terms

Commonly used terms when referring to convertible preferred stock are as follows:

Par Value: Face value of preferred stock, or the dollar amount payable to the holder if the company were to go bankrupt.

Conversion Ratio: The number of common shares an investor receives at the time of conversion of a convertible preferred stock; the ratio is set by the company when the convertible preferred stock is issued.

Conversion Price: The price at which a convertible preferred share can be converted into common shares. Conversion price can be calculated by dividing the convertible preferred stock's par value by the stipulated conversion ratio.

Conversion Premium: The dollar amount by which the market price of the convertible preferred stock exceeds the current market value of the common shares into which it may be converted; may also be expressed as a percentage of the convertible preferred stock's market price.

Example of Convertible Preferred Stock

Consider a convertible preferred stock issued by hypothetical company ABC Inc. at $1,000, with a conversion ratio of 10 and a fixed dividend of 5%. The conversion price is thus $100, and ABC's common shares need to trade above this threshold in order for the conversion to be worthwhile for the investor. Even if the common shares are trading close to $100, it may not be worth it to convert since the preferred shareholder will be giving up their fixed 5% dividend and higher claim on company assets.

If the convertible preferred stock is trading at $1,000 and the ABC common shares are trading at $80, the conversion premium would be $200 (i.e. (1,000 - ($80 x 10)) or 20% ($200 / $1,000). If the common shares move up to $90, the conversion premium shrinks to $100, or 10%.

Thus, the conversion premium influences the price at which the convertible preferred stock trades in the market. A high conversion premium implies that the underlying commons shares are trading well below the conversion price and there is little possibility of a profitable conversion. In this case, the convertible preferred stock will act more like a bond and will be susceptible to changes in interest rates. If the conversion premium is very low — implying that the common stock is trading quite close to the conversion price — the convertible preferred stock will be sensitive to changes in the underlying common shares (those of ABC, in this case) and will act like straight equity.

As the common shares rise, it becomes more attractive to convert. If the ABC common shares move to $110, the preferred shareholder gets $1,100 ($110 x 10) for each $1,000 preferred stock. That's a gain of 10% if the investor converts and sells the common shares at $110.

The danger in converting is that the investor becomes a common shareholder, at the mercy of the swings in the stock price. If the price of ABC stock falls to $75 after conversion, and assuming that the investor continues to hold the common shares, they would now own $750 ($75 x 100) in common shares for each preferred stock (worth $1,000) that they previously owned. This represents a notional loss of $250, and the investor no longer receives the 5% preferred stock dividend or preferential claim on assets.