What is a Cashless Conversion

Cashless conversion is the direct conversion of ownership (from one ownership type to another) of an underlying asset without any initial cash outlay by the holder. Contracts for such securities define all the terms of the conversion at onset of the trade. Many of them automatically trigger the transfer of assets on specific date or in case of a specific event.

BREAKING DOWN Cashless Conversion

Some examples of cashless conversions are from preferred shares or convertible bonds to common stock. Employee stock options, rights and warrants can also be cashless if their exercise prices are zero. However, a more common reason involves selling some of the underlying stock at the time of exercise to pay the exercise price. In this case, they are called cashless exercise.

A preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares generally have a dividend that must be paid out before dividends to common shareholders. Some preferred stock is convertible, meaning it can be exchanged for a given number of common shares under certain circumstances. The board of directors might vote to convert the stock, the investor might have the option to convert, or the stock might have a specified date at which it automatically converts.

A convertible bond is a type of debt security that can be converted into a predetermined amount of the underlying company's equity at certain times during the bond's life, usually at the discretion of the bondholder.

Unless market conditions trigger an automatic conversion, as defined in the contract, the procedure to convert is to simply notify the account that the holder wishes to do so. The converted number of shares replaces the currently held asset with no money due.

Cashless Exercise

A cashless exercise is a transaction in which certain securities are exercised without making any cash payment. Such a transaction utilizes a broker to provide a short-term loan so that the holder exercising the options has enough money to do so. Once the loan to exercise the options is in place, the employee then sells enough of the newly acquired shares to pay back the broker for the loan, fees and taxes. The person exercising the conversion then possesses the remaining shares.

For example, warrants give the right, but not the obligation, to buy or sell a security—most commonly an equity—at a certain price before expiration. The price at which the underlying security is be bought or sold is referred to as the exercise price or strike price. However, in order to be cashless, the warrant itself must be defined as a cashless warrant. In this case, the holder would pay the exercise price from the value of the shares received.

For example, if the warrant is for the purchase of 10,000 shares at $1.00 per share, and the market price of the stock at exercise is $10.00 per share. The holder would, upon exercise, receive the market value of the share ($100,000) minus $10,000 for a total value of $90,000 or 9,000 shares.