What is a 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 conversion. The value of a convertible preferred stock is ultimately based on the performance of the common stock.

Key Takeaways

  • Convertible preferred shares can be converted into common stock at a fixed conversion ratio.
  • Once the common share moves above the conversion price, it may be worthwhile for the preferred shareholders to covert and realize an immediate profit.
  • After a preferred shareholder converts their shares, they give up their rights as a preferred shareholder (no fixed dividend or higher claim on assets) and become a common shareholder (ability to vote and participate in share price declines and rises).
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Convertible Preferred Stock

Understanding Convertible Preferred Stock

Convertible preferred stock is used by corporations for fundraising purposes. Companies can raise capital in two ways: 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. Preferred shares are a type of hybrid security, falling somewhere between debt and equity.

Equity gives shareholders ownership, which gives them voting rights, but they have little claim on assets if the company falters and liquidates. This is because debt holders and preferred stockholders are paid out prior to common shareholders from any assets remaining. 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 shareholder do.

Preferred and common stock will trades 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 can be converted to common shares at the conversion ratio. The conversion ratio is set by the company before the preferred stock is issued. For example, one preferred stock may be converted into two, three, four, and so on, common shares. If the common shares rise, the preferred shareholder may opt to convert their shares into common stock, thus realizing an immediate profit. The price at which converting becomes profitable for the investor is called the conversion price.

Example of Convertible Preferred Stock

Convertible preferred shares priced at $100, with a conversion ratio of five, means that the common stock needs to trade above $20 in order for the conversion to be worthwhile for the investor. Even if the common stock is trading right near $20 it may not be worth it to convert since the preferred shareholder will be giving up their fixed dividend and higher claim on company assets.

As the common shares rise, it becomes more enticing to convert. If the common shares move to $25, the preferred shareholder gets $125 ($25 x 5) for each $100 preferred share. That's a gain of 25% if the investor converts and sells the common stock at $25.

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 collapses to $15 after conversion, and the investor didn't sell at $25, they are worse off than they were before. They own $75 ($15 x 5) in common shares for each preferred stock (worth $100) they owned, and they no longer receive their fixed dividend or claim on assets.