What is a convertible preferred stock?

Convertible preferred stock is a hybrid security that combines the fixed-income properties of preferred stock with the option to convert the shares into common stock equity.

What is convertible preferred stock, and how does it work?

Convertible preferred stock is a type of preferred stock that offers investors both steady income and the potential for future equity growth. It provides similar benefits as preferred stock investments, including:

• Fixed income payments: Investors of preferred stocks receive regular dividend payments.
• Preferential treatment: In the event of bankruptcy, holders of preferred stock have a higher claim on the company’s assets than common stockholders (though they rank below creditors).

The key difference between convertible preferred stock and preferred stock is that investors have the option to convert their preferred shares into a set number of common shares after a specified date. This means holders can potentially benefit from increases in the company’s stock price.

However, this benefit comes with a trade-off: convertible preferred stock often trades at a premium compared to regular preferred shares and sometimes also carries a lower dividend rate.

How does convertible preferred stock work?

Companies issue convertible preferred stock to raise capital without taking on debt or excessively diluting common shareholders. These investments are popular among early-stage companies looking for flexible ways to finance their operations and expansion. 

Holders of convertible preferred stock will earn fixed dividends for as long as they retain the preferred shares, provided the company has the necessary resources to make the payments. They also have the option to convert their preferred shares into a set number of common shares (the conversion ratio) at a predetermined price (the conversion price).

Investors usually exercise the option to convert their shares when the common stock price exceeds the conversion price. This allows them to profit from the equity’s growth; however, it also means they lose their rights as a preferred investor (i.e., fixed dividend payments and preferred claims).

Companies that issue convertible preferred stock sometimes have the option to force a conversion. This often happens when the common stock reaches a specific price threshold.

Convertible preferred stock terms

Key terms to know when learning about convertible preferred stock are:

• Par value: The face value of the preferred stock. This is the amount paid to the holder in a liquidation event.
• Conversion ratio: The number of common shares an investor receives when converting one share of preferred stock which is set by the issuing company. For example, a conversion ratio of 5 means each preferred share converts into five common shares.
• Conversion price: The price at which the preferred stock can be converted into common stock. It’s calculated by dividing the par value of the convertible preferred stock by the conversion ratio. For example, if the par value is $100 and the conversion ratio is 5, the conversion price is $20 per common share.
• Conversion premium: This is the difference between the convertible preferred stock’s market price and the conversion value (based on the common stock price). It reflects the additional cost investors pay for the flexibility of conversion. For example, if the common stock is trading at $22 and the conversion price is $20, the conversion premium is $2 or 10%.

Example of convertible preferred stock

Consider a company issuing convertible preferred stock at $500 per share with a fixed dividend of 6% and a conversion ratio of 5. This means each preferred share can be converted into five common shares. The conversion price is $100 per share ($500 / 5). For the conversion to be worthwhile, the company’s shares need to trade above $100.

If the company’s shares are currently trading at $80, it means the conversion value of the preferred stock is $400 ($80 x 5), which is less than the $500 par value of the preferred stock. At this point, it’s not beneficial for an investor to convert as they’d be giving up their 6% annual dividend and the preferred status in liquidation proceedings.

Say the company’s shares increased to $120. This means the conversion value rises to $600 ($120 x 5), making it potentially profitable for the investor to undertake the conversion. If the investor chooses to convert, they’ll be gaining $100 per share over the initial $500 investment.

Before they make the decision, the investor considers the conversion premium. If the preferred stock is trading at $500 while the common stock is at $90, the conversion value is $450 ($90 x 5), and the premium is $50 (or 10%). A high premium like this means the common shares are still below the conversion price, and converting may not be worthwhile just yet.

As the common shares trade closer to or above the conversion price, the premium decreases, making the preferred stock behave more like equity. For example, if the company’s common shares rise to $110, the conversion value becomes $550 ($110 x 5). The investor now has a 10% gain by converting their preferred shares into common stock and selling them at the higher market price.

The benefits of issuing convertible preferred stock for businesses

Convertible preferred stock provides businesses, particularly early-stage companies, with a flexible means of raising funds. Potential benefits of issuing convertible stock include:

• Minimize dilution: Unlike common stocks, convertible preferred stock allows companies to delay significant share dilution until a higher valuation is reached. Since conversion usually occurs when the common stock price exceeds the conversion price, convertible preferred shares offer a way for businesses to secure capital while potentially minimizing the impact of dilution on existing shareholders.
• Flexible terms: Companies can also structure the terms of convertible preferred stocks to align with their financial strategies. For example, they can choose to redeem or force conversion of the stock after a specified period.
• No voting rights: Holders of convertible stock also often have no voting rights. This can help businesses maintain control over decision-making.
• Non-cumulative dividends: Dividends on convertible preferred stock are often non-cumulative, meaning companies only pay dividends when declared by their board of directors. This means dividends won’t accrue and aren’t required to be made up on a future date. Exact terms vary, however, and some issuers may include cumulative dividend provisions.

Convertible preferred stock vs common stock: Key differences

Convertible preferred stock and common stock vary in terms of benefits, risk, and potential for returns. For example, a convertible preferred stock offers features like fixed dividends and senior claim rights. Common stockholders, on the other hand, have voting rights and the potential for higher returns – but face lower priority in liquidation.

The key differences between convertible preferred stock and common stock include:

• Income potential: Convertible preferred stock is structured to offer fixed dividend payments, which can generate predictable cash flows if the company declares dividends. Common stock, however, provides no guaranteed income, as dividends are only paid if the company decides to distribute them.
• Voting rights: Holders of convertible preferred stock typically don’t have voting rights, which means shareholders have little say in corporate decisions. Owners of common stock often have voting rights (usually one per share).
• Payment priority: Holders of convertible preferred stock have a senior claim over common stock with respect to dividends and liquidation. Preferred shareholders are paid before common shareholders in both situations.
• Risk & volatility: Convertible preferred stock tends to be less volatile than common stock due to its fixed-income component and priority status.
• Liquidity: Convertible preferred stock can be less liquid than common stock as they’re not as widely traded. Common stock, however, are highly liquid assets and easy to trade on stock exchanges.

Risks and considerations when dealing with convertible preferred stock

While convertible preferred stock offers many potential benefits, it also comes with certain risks that must be considered.

 These risks include:

• Interest rate risk: Since convertible preferred stock pays dividends, it is considered a fixed-income investment. This can make them sensitive to interest rate fluctuations. Liquidity risk: Convertible preferred stock can be less liquid than common stock, which can pose a liquidity risk. Investors may struggle to sell their shares at a fair price, particularly during economic downturns or company-specific challenges.
• Credit risk: Convertible preferred stock relies on the creditworthiness of the issuing company. If the company defaults on its debts or faces financial difficulties, it may be unable to pay dividends or redeem its stock.
• Dilution risk: When convertible preferred stocks are converted into common shares, the total number of outstanding shares increases, resulting in potential dilution. This can lead to dilution, reducing earnings per share and potentially decreasing the stock price.
• Market risk: Like other equity investments, convertible preferred stock is exposed to broader market volatility. Economic downturns can cause the stock’s price to drop, affecting both preferred and common shares.
• Call risk: Some convertible preferred stocks include a call provision, which allows the issuing company to redeem the shares at a set price after a specific date. This can result in early redemption, which investors should account for when evaluating these securities.
• Conversion risk: There’s a risk that the convertible preferred stock will not convert into common shares under favourable conditions. This can affect an investor’s opportunity to receive anticipated returns.

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.