DEFINITION of Adjustment in Conversion Terms
A term used to describe the adjustment made to a convertible securities' conversion factor when the exchangeable stock underlying the convertible undergoes a split.
BREAKING DOWN Adjustment in Conversion Terms
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 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 security into a convertible common will be adjusted under many different events suck as:
- Payouts of stock dividends.
- Stock splits
- Stock reclassifications
- 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 Chairman of the Board of Directors, president, chief financial officer, the chief executive officer, controller, principal accounting officer, treasurer or general counsel. The Officer’s Certificate, which shows delineates the facts on which such conversion price adjustment is based, must be archived in a secure location. In the event of a conversion adjustment, the issuing company is obligated to 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 option conversion extends to shareholder the right to convert his or her preferred shares into common shares when he or she believes it's 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. Contrarily, 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”.