Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time 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 conversion. The value of convertible preferred stock is ultimately based on the performance, or lack thereof, of the common stock.
Convertible preferred stock is used by corporations for fundraising purposes. Companies can raise capital in two ways, through debt or equity. Debt must be paid back regardless of the firm's financial situation, but it generally costs less to obtain after tax incentives. Equity gives up ownership but does not need to be paid back. Both forms of capital fundraising have their advantages and disadvantages, but there are hybrid securities available in the market to help investors carve out the perfect investment product. One such hybrid product is convertible preferred stock.
Equity gives shareholders ownership, which gives them voting rights, but they have no claim on assets if the company falters and liquidates. Preferred stock is a hybrid security that gives the shareholder a claim on assets in exchange for voting rights. It is not listed with common stock and trades at a different price due to its variations. 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 share 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 lower dividend, convertible preferred stock gives shareholders the ability to participate in share price appreciation.
At a certain price, convertible preferred stock can be converted to common shares. This price is called the conversion ratio. The conversion ratio is set by the company before the stock is issued. Convertible preferred shares priced at $100, with a conversion ratio of five, have a conversion price equal to the share price divided by the conversion ratio, or $20. This means the common share price needs to trade higher than $20 for the investor to gain value from the conversion.