Definition
Convertible Preferred Stock is a type of preferred stock that gives holders the option to convert their preferred shares into a fixed number of common shares, usually at any time after a preset date. This type of stock combines features of debt, in that it pays fixed dividends, and equity, in that it has potential to appreciate in price. The conversion from preferred to common stock can potentially bring greater financial returns to the investor.
Key Takeaways
- Convertible Preferred Stock refers to a type of preferred stock that holders can convert into a specified number of common shares after a predetermined date. This gives investors a chance for potential upside, should the issuer’s common stock price increase.
- Convertible Preferred Stock provides investors with the safety of fixed dividends like bonds, and at the same time, an opportunity to benefit from a rise in stock price, functioning as a hybrid security.
- The conversion ratio, determined at the time of issuance, signifies the number of common shares each preferred share can be converted into. This ratio plays a significant role in determining the value of convertible preferred stock, adding flexibility for the investor.
Importance
Convertible Preferred Stock is significant in finance because it allows its holders more flexibility and potential for gain in their investment.
This type of stock permits the owner to convert preferred shares into a fixed number of common shares, typically at any time they choose.
This provides an investor the benefit of receiving dividends from preferred shares while also having the opportunity to participate in company growth through the conversion into common shares, which could increase in value.
Furthermore, convertible preferred shares hold a higher claim on assets and earnings than common stock, which means in cases such as liquidation or bankruptcy, convertible preferred stockholders will be compensated before common stockholders.
Therefore, Convertible Preferred Stock presents an investor a potential for upside return with a downside protection.
Explanation
Convertible preferred stock is a specific type of preferred security designed to offer flexibility and potential for appreciation. It entitles the holder to a fixed dividend and a share in the company’s profits ahead of common stockholders. However, what sets it apart from regular preferred stock is its ability to be converted into a predetermined number of common shares, typically at the discretion of the holder.
This feature makes it highly attractive to investors by offering the stability of income from the dividends and the opportunity for capital gains. The purpose of convertible preferred stocks is dual-faceted. For companies, they serve as an instrument to raise capital without increasing their loan capital.
Unlike borrowing, issuing convertible preferred stocks does not mandate a company to make interest payments or repay the principal amount. For investors, it acts as a hedging mechanism against the company’s potential downside. While they enjoy a steady income stream in the form of dividends, investors also preserve an option to convert these shares into common stocks at their will if they anticipate the company’s common stock price will rise significantly.
Thus, convertible preferred stocks are a hybrid security, offering features of both equity and debt.
Examples of Convertible Preferred Stock
Tesla: In 2014, Tesla issued $2 billion in convertible preferred shares as an alternative way to raise capital without increasing their debt. Investors were interested in the convertible preferred shares because they offered a higher yield than Tesla’s common shares at the time, and the conversion feature offered potential additional returns if Tesla’s stock price increased.
Bank of America: During the 2008 financial crisis, Bank of America launched a convertible preferred stock to boost its capital. Warren Buffet’s Berkshire Hathaway bought $5 billion of Bank of America’s convertible preferred stock which paid a 6% annual dividend. Not only did this investment provide Bank of America with the needed capital, but it also gave Berkshire Hathaway the option to convert those shares into common stock at a later date and earn greater returns if the share price appreciated.
Dropbox: In 2014, before it went public, Dropbox raised $500 million through issuing convertible preferred stock. The investors in this financing round were granted not only a return on investment in the form of dividends, but also the assurance that they could convert their preferred shares into common shares in the event of Dropbox’s IPO, thus potentially leading to higher yields if Dropbox’s common stock performed well post-IPO.
FAQs for Convertible Preferred Stock
What is a Convertible Preferred Stock?
Convertible Preferred Stock is a type of preferred stock that gives holders the right to convert their preferred shares into a fixed number of common shares, usually anytime after a predetermined date.
What are the benefits of Convertible Preferred Stock?
Convertible Preferred Stock provides investors with the potential for capital appreciation if the company’s common stock price rises, and also offer dividends and preference during liquidation event, making it an attractive investment option.
What is the difference between Preferred Stock and Convertible Preferred Stock?
While both preferred stocks and convertible preferred stocks offer dividends, the latter also gives investors an option to convert their preferred shares into common shares. This is a notable advantage for potential growth in the company’s common stock price.
How can I convert my Preferred Stock into Common Shares?
Conversion of preferred stock into common shares is usually as simple as contacting the broker or company in charge of the stock and asking them to make the conversion. However, the exact process depends on the company’s specific procedures and the terms of the stock agreement.
Can Convertible Preferred Stock be converted back into Preferred Stock?
No, the process is not reversible. Once a convertible preferred stock is converted into common stock, it cannot be converted back to a preferred stock.
Related Entrepreneurship Terms
- Par value
- Common Stock Conversion
- Conversion ratio
- Mandatory Conversion
- Call Provision
Sources for More Information
- Investopedia: A comprehensive site offering definitions of finance terms, including Convertible Preferred Stock.
- The Balance: A finance-focused site that provides detailed articles on many finance concepts like Convertible Preferred Stock.
- Corporate Finance Institute: A professional site providing courses and free resources on various aspects of finance including types of stocks.
- NASDAQ: The official site for the NASDAQ stock market provides information on various financial concepts and current market data.
