There are different types of preferred stock which include: non-cumulative, participating, convertible, cumulative, etc. Here, our focus will be convertible preferred stocks.

convertible preferred stock is a type of stock that acts both as equity and debt thereby making it a mixed instrument. It is equity because it can be converted to ordinary shares at or after a predetermined date. It is debt because when unconverted, its holder is entitled to get paid a fixed dividend either quarterly or annually by the issuing company.

In order to understand convertible preferred stocks and how they work, we shall be looking at their definition, formula, and associated calculations with examples. We shall also examine its characteristics, pros, and cons as well as some frequently asked questions on the subject matter.

Convertible preferred stocks are also known as convertible preferred shares or convertible preferreds or convertibles. They are so named due to their primary feature of being able to be converted into a specific number of common shares at or after a predetermined date.

As a result of this conversion option, the value of the convertible preferreds is partly dependent on the market value of the common stocks. Furthermore, the number of common shares received at conversion is usually indicated in the convertibles prospectus or agreement.

For most convertible preferred stocks, conversion rights belong to the shareholder who can then decide to either convert to common shares or keep on holding their stocks as convertibles. However, there are instances when the right to convert may be at the choice of the issuing company or be an innate part of the stocks.

If the right to convert belongs to the issuing company, they decide when the conversion takes place. If it is an innate part of the stocks, it means the stocks automatically get converted at or after a predetermined date.

Convertible preferred stocks like all other stock types serve as a means of raising funds for expansion, purchase of physical assets or intangible assets as well as other operational activities for the issuing companies.

Startups especially issue convertibles to attract investors, since most investors usually prefer to invest in companies that are already well established and only invest in startups that issue convertibles because of the conversion option it offers. This makes convertibles an investment option for those who purchase them.

Characteristics of convertible preferred stocks

1. Earn a fixed dividend.
2. Can be converted to common shares.
3. Have a claim on assets at bankruptcy or liquidation.
4. Can earn a profit.
5. Preference during dividends payment.

When talking about characteristics, we are referring to those features that aid in making convertible preferred stocks distinct from other types of stocks, thereby putting them in a class of their own. Below, we shall have a look at these features.

Earn a fixed dividend

Being a type of preferred, convertibles get paid a fixed dividend which is usually a percentage of its par value or a specified dollar amount. The dividends are mostly paid yearly but some companies pay them quarterly. And since they typically do not have a maturity date, convertible preference shareholders enjoy this fixed dividend in perpetuity unless they convert to ordinary stocks.

Can be converted to common shares

The conversion feature is the most prominent characteristic of convertible preferred stocks. Investors find this characteristic useful since it gives them the chance to enjoy higher returns when they convert to common shares and these stocks undergo an upward change in price. Usually, convertibles are exchanged at the stockholders’ request, however, there are exceptions where the terms of the stock allow the exchange to be initiated by the company or automatically after a specified date.

Have a claim on assets at bankruptcy or liquidation

Considering that convertibles are preferreds, their holders have a claim on the issuing company’s assets in a situation where the company goes bankrupt or has to liquidate. This feature is valid as long as the investor does not convert their stocks.

Can earn a profit

Unlike other preferreds, holders of convertibles could earn a profit when they convert to common stocks. This is because common stockholders are entitled to receive any excess dividends that have been declared by the issuing company as they do not have a fixed dividend rate.

Preference during dividends payment

When it comes to payment of dividends, convertible preference shareholders receive preferential treatment along with other types of preferred stockholders and bondholders as they get paid first before common stockholders who get paid later and only when the dividends that have been declared by the issuing company are sufficient to pay them too.

Pros and Cons

Convertible preferred stocks have characteristics that are considered pros by the issuing company and stockholders, some of their features are considered cons by the aforementioned. The characteristics one will consider a pro or a con depends on which side of the divide they fall in. We shall discuss some of these pros and cons to the issuing companies and the stockholders below.

Pros to the issuing company

1. Maintain control.
2. Source of capital.
3. Decreases cash outflows.

Companies continually seek ways to fund their operations that offer the most advantages to them, below are some reasons why issuing convertible preferred stock is a pro to the issuing company.

Maintain control

Convertible preferred stockholders have no voting rights in the issuing company, this enables the owners to maintain control since all decisions pertaining to the business are solely made by them without any external influence. Businesses seeking funds who do not want external influence in their policies can issue convertibles.

Source of capital

Since this share type has no maturity date, it is considered a source of permanent capital for the companies that issue them.

Decreases cash outflows

When holders of convertible preferred stocks convert their shares to common stock, the issuing company’s cash outflows are likely to decrease since they are not obligated to pay dividends to common stockholders.

Pros to the stockholders

1. Steady source of income.
2. Receive priority during dividend payment.
3. Can be converted to common shares.
4. Have voting rights after conversion.
5. Can make a profit.
6. Have a claim on the company’s assets.

Investors are always on the lookout for investment options that offer pros to them by adding considerably or consistently to their earnings. Here, we shall have a look at the pros of convertible preferred stocks to their holders.

Steady source of income

Convertible preference shares are entitled to a fixed dividend for as long as their issuing company is in business and their holders do not convert them to ordinary shares. The fixed dividend saves as a steady income source for the stockholders.

Receive priority during dividend payment

Convertibles receive priority during dividend payment along with bondholders and other types of preferred stock provided that their issuing company declares dividends.

Can be converted to common shares

The main reason why convertible preferred stocks are named like that is that they can be converted to common stocks. This conversion is a bit tricky most times as it can either be initiated by the stockholder or the issuing company or automatically after a specified date.

Have voting rights after conversion

Once a convertible preference shareholder converts their shares to ordinary shares, they have voting rights and can partake in the decision-making processes of the issuing company. Typically, one ordinary share is equivalent to a vote.

Can make a profit

After conversion, the stockholder can make a profit on their stocks since voting shares trade on the stock exchange and their prices tend to rise. Additionally, voting shareholders are entitled to receive any leftover excess dividends since they generally do not have a fixed dividend rate.

Have a claim on the company’s assets

These stockholders have a claim to the issuing company’s assets in cases of bankruptcy or liquidation along with other creditors, bondholders, and preferred stockholders provided they have not converted to ordinary shares.

Cons to the issuing company

1. Consistent cash outflows.
2. Stock dilution.
3. Reduction of control.

Although companies want sources of capital with advantages rather than disadvantages to them, no source of capital that does not have some form of demerits attached to it. Below, we shall consider some of the cons associated with issuing convertible preferred stocks.

Consistent cash outflows

Convertibles are entitled to a fixed dividend, which results in consistent cash outflows for the issuing company.

Stock dilution

When convertible preferred stockholders convert their stocks to ordinary shares, it could lead to stock dilution which is a situation whereby the ordinary share price goes down due to an increase in its number without a corresponding increase in the issuing company’s value. The issuing company could offer to buy back some of these converted shares to prevent stock dilution.

Reduction of control

The control that the issuing company has reduces when holders of convertibles convert their shares to voting shares since the conversion allows them to be part of the decision-making processes of the company.

Cons to the stockholders

1. Have no say in the issuing company.
2. Cannot make a profit.
3. No guaranteed income.
4. Could lose after conversion.
5. No claim on assets.

As with the issuing companies, stockholders also face some risks. These cons could be a result of converting to common stocks while some are there even before the conversion. We shall discuss these cons below.

Have no say in the issuing company

Considering that convertible preferred stocks do not typically come with voting rights, it means that its holders have no say in the issuing company since they cannot vote on policies, board members’ elections, or any other activity of the company that involves voting.

Cannot make a profit

Convertible preferred stockholders cannot make a profit since their dividend rate is already fixed and they do not receive any addition even when there are excess dividends.

No guaranteed income

Since common stockholders have no fixed dividends, only get paid from the leftover dividends, and the issuing company is not obligated to pay them dividends; the convertible stockholders who convert their stocks to common stocks have no guaranteed income.

Could lose after conversion

Considering that some convertible preferred stocks agreement provides that the issuing company can convert or that it automatically converts at a predetermined date, the stockholder could be at the losing end especially if the conversion occurs on a date when the common share price is lower than the conversion price. Additionally, since the price of common shares can be altered negatively by market forces, it could lead to a loss for the stockholder after conversion.

No claim on assets

Once convertibles have been converted to voting shares, the shareholder no longer has a claim on the issuing company’s assets during bankruptcy or liquidation.

Convertible preferred stocks formulas

1. Conversion ratio
2. Conversion price or conversion parity price

These two formulas are important to the holders of convertible preferred stocks. They work hand in hand to tell the stockholder the number of voting shares they are entitled to a conversion and the price at which these shares need to trade for them to make a profit from the conversion.

Conversion ratio

This formula tells the stockholder how many common shares they will get when they decide to convert each of their convertibles, it is expressed as; Conversion ratio = Par value of convertible preferred stock ÷ Conversion price of convertible preferred stock

Conversion parity price

The conversion parity price formula tells the stockholder the price at which the ordinary shares need to be trading for them to make a profit on the conversion, it is expressed as; Conversion parity price = Price of the convertible preferred stock ÷ Conversion ratio

Calculations on convertible preferred stocks

Example 1

Assuming a shoe manufacturing company issued 100,000 convertible preferred stocks at a par value of $210, dividend rate of 4% quarterly, and a conversion price of $30, if Grace purchases 10,000 convertibles, what will be the conversion ratio?

We can determine the conversion ratio by simply substituting the information given into the formula

Conversion ratio = Par value of convertible preferred stock ÷ Conversion price of convertible preferred stock

Conversion ratio = $210 ÷ $30

Conversion ratio = 7

This means that Grace is entitled to 7 common shares for each convertible preferred stock she owns.

Example 2

John holds 1,000 convertibles of a tech startup if the dividend yield is 15% per annum, the par value of each convertible is $500 and the conversion price is $100. How many voting shares will he get if he converts all his convertibles?

In order to find out how many shares he will get at conversion, we will need to first find out the conversion ratio using

Conversion ratio = Par value of convertible preferred stock ÷ Conversion price of convertible preferred stock

Conversion ratio = $500 ÷ $100

Conversion ratio = 5

To find out the number of voting shares John will get, we simply multiply the total number of convertibles he owns by the conversion price which is 1,000 x 5 = 5,000. Therefore, he will get 5,000 voting shares upon converting all his convertible preferred stocks.

Example 3

Assuming Jane purchases 200 convertible preference shares in an agrochemical company, if the price of each is $100 and the conversion ratio is 4, we can calculate the conversion price of each convertible using

Conversion parity price = Price of the convertible preferred stock ÷ Conversion ratio

Conversion parity price = $100 ÷ 4

Conversion parity price = $25

The above result means that, for Jane to make a profit on her conversion, the agrochemical’s common stocks need to trade above $25.

Example 4

Assuming Michael purchased 200 shares of convertible preference shares in a software company, each share cost $600 with a dividend yield of 5% per annum and a conversion ratio of 10 after 2 years. We can find out the conversion parity price as follows

Conversion parity price = Price of the convertible preferred stock ÷ Conversion ratio

Conversion parity price = $600 ÷ 10

Conversion parity price = $60

Therefore, if the software company’s ordinary shares trade below $60 after 2 years when Michael can convert his preference shares to ordinary shares, it means he will incur a loss if he chooses to convert his shares at that point. It will thus be wiser for him to wait until the ordinary shares are trading above that price before he converts his shares.

Frequently asked questions

Conclusion

Convertible preferred stocks are generally appealing to startup companies who want to raise capital without immediately having to deal with sharing the control of the company with investors. It is also appealing to investors who do not want to take the immediate risk of purchasing common shares due to its high volatility.