What Is Convertible Preferred Stock?

Convertible preferred stocks are preferred shares that include an option for the holder to convert them 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 the conversion. The value of a convertible preferred stock is ultimately based on the performance of the company's common stock.

Understanding Convertible Preferred Stock

Corporations use convertible preferred stock to raise capital. These securities are especially useful as a financing medium for early-stage companies as they can offer greater flexibility to investors, making them an attractive option. That is, the investor has the promise of regular dividends and the potential for stock price growth in the future.

Preferred stock is a class of equity capital issued by a corporation that has a higher claim on assets and earnings than common stock. Preferred shares typically pay steady dividends, while common stock pays dividends only if and when they are approved by the board of directors based on the company's recent financial performance.

Preferred shares do not usually come with voting rights, as common shares do. As such, preferred stock is often thought of as a hybrid between a corporate bond and common stock.

The Convertible Option

Convertible preferred stock is distinguished by the fact that it contains an embedded option that allows the holder to trade it for a specified number of common shares at some point in the future. This conversion option provides a potential upside for the holder, as the value of the common stock could increase over time. Meanwhile, it has the benefits of preferred stock. However, this advantage comes at a price. Convertible preferred stock typically trades at a premium over regular preferred shares and may also carry a comparatively lower dividend rate.

Convertible Preferred Stock Terms

Commonly used terms when referring to convertible preferred stock are as follows:

• Par value: Face value of preferred stock, or the dollar amount payable to the holder if the company were to go bankrupt.
• Conversion ratio: The number of common shares that an investor receives at the time of the conversion of a convertible preferred stock. The ratio is set by the company when the convertible preferred stock is issued.
• Conversion price: The price at which a convertible preferred share can be converted into common shares. Conversion price can be calculated by dividing the convertible preferred stock’s par value by the stipulated conversion ratio.
• Conversion premium: The dollar amount by which the market price of the convertible preferred stock exceeds the current market value of the common shares into which it may be converted. It may also be expressed as a percentage of the convertible preferred stock’s market price.

Example of Convertible Preferred Stock

Consider a convertible preferred stock issued by the hypothetical company ABC Inc. at $1,000, with a conversion ratio of 10 and a fixed dividend of 5%. The conversion price is thus $100, and ABC’s common shares need to trade above this threshold for the conversion to be worthwhile for the investor. Even if the common shares are trading close to $100, it may not be worth it to convert since the preferred shareholder will be giving up a fixed 5% dividend and a higher claim on company assets in the event of liquidation. If the convertible preferred stock is trading at $1,000 and the ABC common shares are trading at $80, then the conversion premium would be $200 (i.e., (1,000 - ($80 × 10)) or 20% ($200 ÷ $1,000). If the common shares move up to $90, the conversion premium shrinks to $100, or 10%. Thus, the conversion premium influences the price at which the convertible preferred stock trades in the market. A high conversion premium implies that the underlying common shares are trading well below the conversion price and there is little possibility of a profitable conversion. In this case, the convertible preferred stock will act more like a bond and will be susceptible to changes in interest rates. If the conversion premium is very low—implying that the common stock is trading quite close to the conversion price—the convertible preferred stock will be sensitive to changes in the underlying common shares (those of ABC, in this case) and will act like straight equity. As the common shares increase in price, a conversion becomes more attractive. If the ABC common shares move to $110, the preferred shareholder gets $1,100 ($110 × 10) for each $1,000 preferred stock. That’s a gain of 10% if the investor converts and sells the common shares at $110.

The Risk in Converting

The danger in converting is that the investor then becomes a common shareholder and is at the mercy of swings in the stock price. If the price of ABC stock falls to $75 after conversion, and the investor continues to hold the common shares, they would now own $750 ($75 × 10) in common shares for each preferred stock (worth $1,000) that they previously owned. This represents a notional loss of $250, and the investor no longer receives the 5% preferred stock dividend or has a preferential claim on assets.

The Bottom Line

Combining features of both preferred and common stock, convertible preferred shares are a hybrid security with the benefit of a steady, fixed dividend and the potential for capital appreciation via conversion. Investors in this type of security value their flexibility. The conversion price, or the number of common shares that one share of convertible preferred stock is good for, is determined at the time of issuance and may be adjusted subsequently by the issuer.