What Is Adjustment in Conversion Terms?

Adjustment in conversion terms refers to a change in the conversion price to reflect the change in value of the security, such as after a stock split.

Key Takeaways

  • Adjustment in conversion terms refers to a change in the conversion price to reflect the change in value of the security, such as after a stock split.
  • An adjustment in conversion terms can be a scheduled event or can be dependent on any related changes so that the holder of the convertible security remains unaffected.
  • An adjustment in conversion terms must compute the adjusted conversion price in accordance with the Officer's Certificate, which delineates the facts on which such conversion price adjustment is based.

Understanding Adjustment in Conversion Terms

This term is most commonly used to describe the adjustment made to a convertible securities' conversion factor when the exchangeable stock underlying the convertible undergoes a split. In some convertibles, an adjustment in conversion terms is a scheduled event. Otherwise, these adjustments are made in order to ensure that the holder of the convertible remains unaffected by any related changes.

For example, if a convertible security for Company ABC has an exchange privilege of one share of common stock for $50, and the common share of ABC splits 2 for 1, then the exchange ratio will be adjusted to one common share for $25.

The conversion price of a security into a convertible common stock can be adjusted under many different events, such as:

  • Payouts of stock dividends
  • Stock splits
  • Stock re-classifications
  • Any combination of the above events

When an adjustment is made to a conversion price, the company must compute the adjusted conversion price in accordance with the Officer's Certificate—a document signed by a senior-level company executive, such as the board chairman, president, chief financial officer, the chief executive officer, controller, principal accounting officer, treasurer or general counsel. The Officer's Certificate delineates the facts on which such conversion price adjustment is based. In the event of a conversion adjustment, the issuing company will usually send a notice of the new price to shareholders via first-class mail.

The conversion ratio is subject to change. Any time new shares are issued, the existing shareholders will be subject to dilution. The addition of more preferred shares or common shares will dilute the preferred shareholder as the total number of shares increases. It is common to have anti-dilution protections that adjust the conversion ratio to counteract the effect of dilution through new issuances.

Optional Conversion versus Mandatory Conversion

An optional conversion extends to shareholders the right to convert their preferred shares into common shares when they believe it is advantageous to do so—namely, when the buyout of the converted common shares will yield higher returns than preferred shares. This situation often occurs when there's a low liquidation preference multiple, coupled with a cap on a shareholder's participation rights.

In contrast, mandatory conversion rights require holders to convert their shares of preferred stock into shares of common stock. This happens automatically and is sometimes known as "automatic conversion."