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Convertible Preferred Stock: Definition & Advantage

Instructor: Mark Koscinski

Mark has a doctorate from Drew University and teaches accounting classes. He is a writer, editor and has experience in public and private accounting.

In this lesson, you will learn about some of the differences between common and preferred stock, with an emphasis on convertible preferred stock issues.

Convertible Preferred Stock

Your business is expanding rapidly and you need to purchase new equipment. Your personal savings are depleted and you have asked the bank to increase your credit line. Unfortunately, the meeting did not go as well as you hoped. The banker was very impressed with your company's potential but was concerned your company is undercapitalized. In other words, increased debt loads would over-leverage the company and increase its risk profile.

Finding New Capital

Since you do not have additional funds at your disposal, you may look to friends and family for additional investors. Unfortunately, your friends and family may be over-leveraged as well and be unable to provide the capital infusion you need. You were not wild about having a minority shareholder anyway. You like the being the sole owner. In this situation, you will need to use equity financing to raise capital.

Wishing to maintain management control often hinders fundraising for small privately held corporations. Outside investors often want a say in corporate management to protect their investment. Minority shareholders in a private company can be outvoted by the majority shareholder on every vote, so they have no real control over management. Also, there is no easy way for a minority investor to sell his shares since the company is not publicly traded.

The Solution: Convertible Stock

After consulting with your financial advisor, you decide preferred stock is the best way to raise new capital. Preferred stock is somewhat different than common stock. Preferred stock shareholders do not vote to elect directors or in other corporate matters, so management retains control of the company. Preferred stock shareholders receive set dividend payments, somewhat like interest payments for a bond. However, no one can force a board of directors to declare a dividend. If cash flow does not support dividends the board can forego the dividend payment at its discretion. There can be a great variation in characteristics among preferred stock issues. You can attempt to tailor the characteristics of the preferred stock to what makes sense for your company.

Convertible Preferred Stock

A potential investor may require some additional protection and/or additional compensation for his investment by requiring the preferred stock to be convertible. Convertible preferred stock can be exchanged for the common stock of the company if certain conditions are met. The contractually set conversion ratio determines the number of common shares each share of preferred stock may be converted into.

Example

Suppose a preferred stock issue carries a 5% dividend and a $1,000 par. It is also convertible into 100 shares of common stock after two years ($10 per share). This may provide additional protection for the investor if dividends are not declared on the preferred stock. After the conversion, the investor has common stock he may then vote. It is even possible the investor can gain control over the company's management if he can gather enough of common stock.

The Upside of Common Stock

The investor may also want to participate in the 'upside' of common stock. He sees your company has a great deal of promise and hopes you will go public someday. The convertible preferred stock allows him to exchange his illiquid investment for common shares that are hopefully increasing in value as your company grows. In the meantime, the investor is receiving a market rate of return through dividend payments.

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