What is Convertible Stock?

Convertible preferred stock, or convertible stock, is a form of hybrid investment that is most commonly offered to venture capitalists that invest in startup businesses.

It’s considered hybrid because it combines the debt of fixed dividend payments with the equity that comes from conversion to common stock.

Convertible stock is generally preferable to common stock because it can enhance profits while protecting against potential losses. However, this depends on the performance of the business and when the investor decides to convert to common shares.

A closer look at convertible stock

Convertible stock is a hybrid investment because it initially provides the investor with preferred shares. The investor receives the agreed dividends and, if the company fails, they have priority over common shareholders when assets are paid out.

After a predetermined date, the investor has the option to convert their preferred stock to common stock. Not only does this mean that they would then receive voting rights but also that they can potentially enjoy greater returns if the company enjoys success.

Once the conversion is completed, the investor will no longer have the rights of a preferred shareholder, but they can take advantage of the same rights that other common shareholders have.

Preferred shares vs. common shares

As mentioned, an investor initially receives an agreed amount of preferred shares.

Preferred shares offer set and agreed dividends, although they do not transfer any voting rights to the holder. If the company were to go bankrupt, preferred shareholders would get priority over the company’s income. In contrast, common shareholders would get their share last, which increases the likelihood that they will only receive a portion of what they’re owed.

Benefits of convertible preferred stock

  • Guaranteed dividends — Preferred stock comes with a fixed and guaranteed dividends, whereas there is no guarantee or even requirement that common shareholders will receive any dividends.
  • Share in increased earnings — Convertible stockholders can convert their holding after a predetermined amount of time. This essentially allows the investor to switch to a more profitable form of stock, thereby optimizing their returns.
  • Protection against failure — If the company performs poorly and its shares fail to increase in value, there is no commitment or requirement for the convertible stockholder to convert. They can retain their holding as preferred stock, ensuring that they get priority over the company’s assets if the business goes bankrupt.

The disadvantages

  • Potentially lower dividend rates — If the company performs better than expected, it may choose to increase the dividends it pays to common stockholders, pushing it above the rate that the preferred stockholder receives.
  • Conversion means a loss of advantages — Once the investor converts their holding from preferred stock to common stock, they will forego all preferred stockholder privileges, with no option to revert. If the company suffers poor results after the investor converts their holding to common stock, they will not have the security of preferred stock.

When to convert convertible stock

There will usually be a predetermined date or event after which a stockholder can convert their preferred stock to common stock.

The most common occasions to convert come after the company submits an initial public offering (IPO), or following a merger or acquisition with another organization. The holder is under no obligation to convert at any time, however, and they may retain their holding as preferred stock for as long as they wish.

What is the conversion ratio?

The conversion ratio is the number of shares of common stock the investor receives for each share of preferred stock they convert.

This rate is set before the preferred stock is issued. It’s usually equivalent to the par value, which is the amount that a stockholder would receive if the company went bankrupt, divided by the conversion price. The conversion price is the cost of converting to common stock.

In summary, convertible stock is preferred stock that, after a predetermined date or event, can be converted to common stock. It is considered a hybrid investment that combines some of the features of debt with those of equity investment. 

Most often offered to venture capitalists, convertible stock is beneficial because it provides fixed dividends as well as the option to convert to common stock if the common stock becomes more profitable. However, it comes with certain disadvantages which should be also kept in mind.