What is a Convertible Preferred Stock? Definition, Feature, And How Does It Work?

Definition

Convertible Preferred Stocks are considered a type of Preferred Stock that allows stockholders to convert their stock holding to common stock at a fixed conversion ratio.

However, this conversion can only take place after a predetermined date. Even though this transaction mostly takes place upon the shareholder’s request, it can be seen that some companies and businesses include this as a clause that conversion can be forced.

In other words, the issuing party can force the stockholders to convert their preferred stock to common stock.

The main reason why companies do this is that preferred stockholders have a fixed rate of return. This means that these shareholders need to be paid the amount on a priority basis.

Similarly, the company is liable to settle the preferred stockholders first in liquidation. Therefore, businesses and organizations might find converting their preferred to common stock viable, depending on what suits them best.

However, this option is only available for convertible preferred stocks. Not all preferred stocks are considered to be convertible.

Features of Convertible Preferred Stock

Convertible Preferred Stocks are similar to normally preferred stocks. They have the following salient features:

  • They have a specific covenant regarding the company holding the right and the discretion to convert normal preferred stock into common stock.
  • Before conversion, convertible preferred stockholders should receive dividends per the normal contractual agreement.
  • A set conversion ratio is mentioned when the shares are issued. For example, the company might issue 1 common share for every 2 convertible preferred shares.
  • The company reserves the right not to convert these shares to common ones. In that case, the shareholders are not liable to pressure the issuing party to convert their shares into common shares.
  • However, some types of convertible preferred stocks also have the option that leaves it to the shareholder to decide when they need to convert the share. In other words, in such share types, convertible preferred stockholders can convert it into common stock whenever they can.
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How do Convertible Preferred Stocks work?

Companies often issue convertible Preferred Stocks to keep the right with themselves to convert and flip preferred shares into common shares.

They normally do that because they want to move the dividend payouts from fixed to variable. Hence, companies might issue these shares, which would eventually be converted back when the company deems them right.

In the same manner, it can also be seen that convertible preferred stock is considered a highly flexible option for companies, predominantly because it gives the companies much-needed leverage to play around with their stock types.

Therefore, it helps companies issue finance at a higher initial cost, which goes down once it is converted back to preferred stock.

Advantages of Convertible Preferred Stock

The greatest advantage of convertible preferred stock is that it is a fairly flexible option for the company.

When the company has recently been formed, and there is ambiguity regarding the dividend payout, shareholders might opt for this option.

Then they might eventually get a common share once they have established a certain level of trust.

Even though common stocks provide shareholders with voting rights, the risk element is higher in the case of common stock because investors are often reluctant to invest in companies without any prior performance history.

Limitations of Convertible Preferred Stock

The main limitation of the convertible preferred stock, from the company’s perspective, is that companies will need to pay dividends to the preferred shareholders until the stocks are not converted.

Also, when stocks are converted, the company might suffer a financial loss because common shares’ prevalent market share rate might be higher than the agreed-upon rate.

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Even though this might prove profitable for investors, it will be a hindrance from the companies’ perspective.

Similarly, once these stocks are converted to common stock, the existing shareholding structure will probably be diluted.

This might not be acceptable to the current common stockholders because their ownership will decrease due to the conversion.