Convertible Preferred Stock: Definition, Feature, And How Does It Work?

Definition

Convertible Preferred Stocks are considered to be a type of Preferred Stock, which gives the option to the 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. Regardless of the fact that mostly this transaction takes place upon the request of the shareholder, yet 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 stock holders have a fixed rate of return. This means that these shareholders need to be paid the amount on a priority basis.

In the same manner, in case of liquidation too, the company is liable to settle the preferred stockholders first. Therefore, businesses and organizations might find it viable to convert their preferred stock to common stock, 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 normal 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 stock holders are supposed to receive dividends as per the normal contractual agreement.
  • There is a set conversion ratio that is mentioned when the shares are issued. For example, the company might say they will issue 1 common share for every 2 convertible preferred shares.
  • The company also reserves the right not to convert these shares to common shares. In that case, the shareholders are not liable to pressurize the issuing party to convert their shares into common shares.
  • However, some type 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 stock holders have the option of converting it into common stock whenever they can.
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How do Convertible Preferred Stocks work?

Convertible Preferred Stocks are often issued by companies when they want 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 then 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 to be a highly flexible option for companies, predominantly because of the reason that it gives the companies a much needed leverage to play around with their stock types.

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

Advantages of Convertible Preferred Stock

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

In the case where the company has recently been formed, and there is ambiguity regarding the dividend payout, shareholders might opt for this option, and then they might eventually get a common share, once they have established a certain level of trust.

Regardless of the fact that common stocks do provide shareholders with voting rights, yet the risk element is higher in case of common stock because of which investors are often reluctant to initially invest in companies without any prior performance history.

Limitations of Convertible Preferred Stock

The main limitation of the convertible preferred stock, from the perspective of the company is the fact that companies will need to pay dividends to the preferred shareholders till the time when the stocks are not converted.

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Also, in the case where stocks are converted, the company might end up suffering a financial loss, because the prevalent market rate of common shares might be higher than the agreed upon rate.

Despite the fact that this might prove to be profitable for investors, yet it will be a hindrance from the perspective of the companies.

In the same manner, 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 as a result of the conversion.

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