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Convertible Preferred Shares

Introduction To Convertible Preferred Shares

Convertible preferred shares are a unique fixed-income security, issued by corporations that grant investors the right to convert shares of preferred stock to common stock on a future date at a specified price. Convertible preferred shares allow companies to raise capital without immediately diluting shareholders. They temporarily provide investors with the comfort of a fixed-income security and later allow them to participate in the equity upside.


What Are The Benefits Of Purchasing Convertible Preferred Shares?

Convertible preferred shares may be attractive for investors with medium risk tolerance. This is because these securities may offer both the safety and income of a fixed-income security and the upside potential of common equity. An owner of a convertible preferred share will always receive dividends paid by the issuer before the owners of common shares. Convertible preferred shares also take priority in the claim-on-assets rank over common stock owners. In simpler terms, if a company goes bankrupt and is forced to liquidate assets, owners of convertible shares will receive capital before common stock owners. Overall, convertible shares may be an attractive way for investors to insulate themselves from immediate risk while also participating in a company's upside.


Converting Convertible Preferred Shares: How It Works

Convertible preferred shares come with a pre-determined "conversion ratio". The conversion ratio tells investors how many shares of common stock they can receive for each convertible preferred share they own. For example, an owner of a convertible preferred share with a conversion ratio of 8 has the right to receive 8 shares of common stock for each convertible preferred share they own, if they decide to convert. The share price of a convertible preferred share is referred to as the par value. In the event of a company's liquidation, convertible preferred share owners would be owed the par value. When an investor decides to convert their convertible preferred shares, they will receive common stocks at a pre-determined price. This price is known as the conversion price and can be calculated using the equation below.

Conversion Price = Par Value / Conversion Ratio


The pre-determined conversion price truly shows the potential benefit of convertible preferred shares. While holding convertible preferred shares, investors will receive dividends and maintain the safety of priority on the claim-on-assets rank. Meanwhile, the company's common stock could rise significantly above the conversion price of the convertible preferred shares held by this investor. This will have allowed the investor to significantly benefit from the equity upside without the inherent risk of holding common stock. On the other hand, if the company goes bankrupt, the convertible preferred share owner will have received dividends and likely had their capital returned while the common stock owner will have lost everything besides a residual claim on the company's assets.


Issuing Convertible Preferred Shares: The Company's Perspective

As with the issuance of any security, issuing convertible preferred shares allows the company to raise capital. Issuing convertible preferred shares can be advantageous to both investors and the issuing companies. One advantage of issuing convertible preferred shares as opposed to common stock is that it does not immediately dilute existing shareholders. The issuance of additional common stock is often a very unpopular decision made by companies as it dilutes the ownership of existing shareholders. Convertible preferred shares will only dilute a common stockholder's ownership if and when holders decide to convert their preferred shares into common shares. An advantage for companies to issue convertible preferred shares as opposed to traditional debt securities is the lack of required interest. Dividends are not required to be paid to convertible preferred share owners unless common stock owners are receiving dividends. So, unlike many debt securities, issuing convertible preferred shares does not require periodic cash expenses for a company.

 

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