Convertible preferred stock: Meaning, Criticisms & Real-World Uses

What Is Convertible Preferred Stock?

Convertible preferred stock is a hybrid security that combines features of both preferred stock and common stock. It pays a fixed dividend, similar to traditional preferred stock, but also grants its holder the option to convert the shares into a predetermined number of common shares of the issuing company. This dual nature positions convertible preferred stock within the realm of Corporate Finance, appealing to investors seeking a balance between income stability and potential capital appreciation. For companies, convertible preferred stock can be an attractive way to raise equity financing while deferring immediate dilution of common equity.

History and Origin

The concept of convertible securities, including convertible preferred stock, emerged as a flexible financing tool, particularly gaining prominence in periods of market uncertainty and for growth-oriented companies. While specific origins are difficult to pinpoint to a single event, the design of convertible preferred stock evolved to bridge the gap between pure debt financing and common equity. Its use became especially prevalent in the venture capital market, where it has become a dominant financial contract for funding early-stage companies. Investors in these private financing rounds often acquire convertible preferred stock due to its unique features, which provide both downside protection and upside potential in a developing enterprise. According to Allen Latta's insights, the "convertible" feature is fundamental to many of the rights, privileges, and preferences granted to preferred stock investors in venture capital financing.⁶

Key Takeaways

Convertible preferred stock offers investors a combination of regular dividends and the potential to convert into common stock.
It provides downside protection through its fixed-income characteristics and a liquidation preference, typically ranking above common stockholders.
Issuers often utilize convertible preferred stock to raise capital while delaying immediate equity dilution until the company reaches higher valuations or specific milestones.
The decision to convert usually rests with the investor, allowing them to benefit from significant increases in the common stock price.
Understanding the conversion ratio and conversion price is crucial for evaluating the potential upside of convertible preferred stock.

Formula and Calculation

A key calculation for convertible preferred stock involves the conversion ratio and the conversion price.

The Conversion Ratio (CR) is the number of common shares an investor receives for each share of convertible preferred stock. This ratio is set at the time of issuance and can be adjusted under specific circumstances, such as a stock split.

The Conversion Price (CP) is the effective price per share at which the preferred stock can be converted into common stock. It is calculated as:

CP = \frac{\text{Preferred Stock Par Value (or Issue Price)}}{\text{Conversion Ratio}}

For example, if a convertible preferred stock has a par value of $\$1,000$ and a conversion ratio of 20:1, the conversion price is $\$1,000 / 20 = \$50$ per common share. This means the investor effectively pays $\$50$ for each common share obtained through conversion.

The Conversion Value (CV) represents the market value of the common shares into which the preferred stock can be converted.

CV = \text{Conversion Ratio} \times \text{Current Market Price of Common Stock}

Interpreting the Convertible Preferred Stock

The value of convertible preferred stock is influenced by two primary components: its fixed income component (its value as a bond, based on dividend payments and its liquidation preference) and its equity component (its value as an option to convert into common stock). Investors typically interpret the convertible preferred stock's value by comparing its current market price to its conversion value and its straight preferred stock value.

If the common stock's market price rises significantly above the conversion price, the convertible preferred stock will trade closely with its conversion value, behaving more like common stock. This indicates that the equity upside is driving its valuation, making conversion more attractive for potential capital gains. Conversely, if the common stock performs poorly and its price falls below the conversion price, the convertible preferred stock tends to trade closer to its straight preferred stock value, acting more like a traditional fixed-income security. This provides a "floor" to the investment's value, as outlined in a U.S. Securities and Exchange Commission investor bulletin.⁵ This dual behavior offers investors a unique balance of risk and reward within their investment strategy.

Hypothetical Example

Consider "InnovateTech Inc." which issues convertible preferred stock with a par value of $\$100$ per share and a fixed annual dividend of $\$5$. Each preferred share can be converted into 4 shares of InnovateTech's common stock.

Initial Scenario: An investor purchases 100 shares of this convertible preferred stock for $\$10,000$. The common stock is currently trading at $\$20$ per share.
- Conversion Ratio: 4:1
- Conversion Price: $\$100 \text{ (par value)} / 4 \text{ (conversion ratio)} = \$25).
- Conversion Value: \(\$20 \text{ (common stock price)} \times 4 \text{ (conversion ratio)} = \$80).
  At this point, the conversion value (\(\$80$) is less than the preferred stock's par value ($\$100$), so the investor would likely prefer to hold the preferred stock for its dividends.
Growth Scenario: Two years later, InnovateTech launches a successful new product, and its common stock price rises to $\$35$ per share.
- New Conversion Value: $\$35 \text{ (new common stock price)} \times 4 \text{ (conversion ratio)} = \$140).
  Now, the conversion value (\(\$140$) is significantly higher than the preferred stock's par value ($\$100$) and its initial conversion price of $\$25$. The investor decides to convert their 100 preferred shares. They receive $100 \text{ shares} \times 4 = 400$ shares of common stock. These 400 common shares are now worth \(400 \text{ shares} \times \$35/\text{share} = \$14,000). This demonstrates how the conversion feature allows investors to participate in the company's growth.

Practical Applications

Convertible preferred stock is a versatile financing instrument with several practical applications across different sectors.
It is a cornerstone of venture capital financing for startups and growth-stage companies. These companies often issue convertible preferred stock to attract investors who want a senior claim and a fixed return while also retaining the flexibility to convert to common equity if the company performs well and goes public or has a significant liquidity event. The terms of these offerings are typically outlined in a term sheet.

Beyond startups, larger corporations may also issue convertible preferred stock as a strategic financing option. For instance, financial institutions might use it to bolster regulatory capital levels without immediately diluting common shareholders, as discussed in a Vorys law firm analysis.⁴ It can also be a mechanism for companies to access capital markets when conventional debt financing might be more expensive due to high interest rates.

Limitations and Criticisms

While convertible preferred stock offers distinct advantages, it also carries certain limitations and criticisms. A primary concern for common shareholders is the potential for dilution. When convertible preferred shares are converted into common stock, the number of outstanding common shares increases, which can reduce the ownership percentage of existing common shareholders and potentially dilute earnings per share. This risk is amplified if the conversion terms are based on fluctuating market prices, leading to what are sometimes termed "toxic" or "death spiral" convertibles, as highlighted by the U.S. Securities and Exchange Commission.³

For investors, convertible preferred stock typically offers lower dividends compared to non-convertible preferred stock because of the added value of the conversion option. Investors also face the risk that the common stock's price may not rise sufficiently to make conversion profitable, meaning they might not realize the anticipated capital appreciation. In such cases, the investor effectively holds a traditional preferred stock with a lower yield. The risk of conversion not occurring as hoped is a notable drawback.²

Convertible Preferred Stock vs. Convertible Bonds

Convertible preferred stock and convertible bonds are both hybrid securities that can be converted into the issuer's common stock, but they differ fundamentally in their underlying nature. Convertible preferred stock is an equity instrument, representing ownership in a company. While it typically offers fixed dividends and a liquidation preference over common shareholders, it does not carry a maturity date or a contractual obligation for the issuer to repay principal.

In contrast, a convertible bond is a debt instrument. It pays interest (coupon payments) and has a fixed maturity date at which the principal amount must be repaid by the issuer. This gives convertible bonds a stronger downside protection as they behave more like traditional bonds if the common stock does not perform well. However, this also means they typically offer lower interest rates than non-convertible bonds due to the embedded equity option. While both offer the opportunity for capital appreciation via conversion, convertible preferred stock aligns more with equity investments, whereas convertible bonds retain their debt characteristics. The Fidelity Investments guide provides further insights into these differences.¹

FAQs

Q: Why do companies issue convertible preferred stock?

A: Companies issue convertible preferred stock to raise capital by attracting investors who desire regular income from dividends combined with the potential for equity growth. It allows companies to defer dilution of common shares until the business matures or hits specific performance milestones, making it particularly popular in venture capital financing.

Q: What is the main advantage of convertible preferred stock for an investor?

A: The main advantage for an investor is the combination of stability and growth potential. Investors receive consistent dividends like traditional preferred stock, while also having the option to convert their shares into common stock if the company's value significantly increases, allowing them to participate in the upside.

Q: How does the conversion ratio affect the value of convertible preferred stock?

A: The conversion ratio directly determines how many common shares an investor receives upon converting one preferred share. A higher conversion ratio means more common shares, which generally increases the preferred stock's value when the common stock price rises. This ratio is crucial for calculating the effective conversion price and potential capital gains.

Q: Is convertible preferred stock less risky than common stock?

A: Generally, yes. Convertible preferred stock offers more downside protection than common stock because it typically pays fixed dividends and has a liquidation preference, meaning preferred shareholders are paid before common shareholders in the event of liquidation. However, it still carries equity-related risks, and its value can decline if the company performs poorly.

Q: Can convertible preferred stock be "forced" to convert?

A: In some cases, yes. While investors typically have the option to convert, certain provisions in the preferred stock's terms can allow or even mandate the company to force conversion under specific conditions. This often occurs if the common stock price reaches a certain level and stays there for a defined period, or upon a major event like an initial public offering (IPO).