Convertible Preferred Stock: Formula & Examples

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 the main characteristics of convertible preferred stock. You will also learn some of the advantages and disadvantages of convertible preferred stock for the issuer and the investor.

The Problem: Finding New Capital

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

No one around you has additional funds at their disposal. Finding an outside investor is necessary but there does not seem to be a market for your company's common stock. You will therefore need to use equity financing to raise capital. Your banker will feel much more comfortable if you or other investors have more 'skin in the game'.

The Solution: Convertible Preferred Stock

After consulting with your financial advisor, you decide preferred stock is the best way to raise new capital. Preferred stock shareholders do not vote on corporate matters such as electing directors, so you retain management control of the company. Preferred stock receives 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 great variation in characteristics among preferred stock issues. You can tailor the characteristics of the preferred stock to fit the needs of your company, and to make it more attractive for investors.

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 company's common stock at a prearranged conversion rate and after a certain date. The contractually set conversion ratio determines the number of common shares each share of preferred stock may be converted into.

Upside of Convertible Preferred Stock

One important reason investors may want convertible preferred stock is they may also want to participate in the 'upside' of common stock. They see your company as having a great deal of promise and hope you will go public someday. The convertible preferred stock allows them to exchange their illiquid investment in the preferred stock for common shares that are hopefully increasing in value since your company is growing. In the meantime, they are receiving a market rate of return through dividend payments.

Suppose a preferred stock issue carries a 5% dividend and a $1,000 par value. It is also convertible into 100 shares of common stock after two years. This is a 10:1 conversion ratio, implying a break-even common stock price of $10 per share. The investor will consider converting his/her preferred stock into common stock when the price of the common exceeds $10. If the investor converts while the common stock has a value of say, $8, s/he will lose money. If the common stock is trading for $14, the investor stands to make a 40% profit on his/her investment and receive dividends for the time s/he held preferred stock. This can be quite lucrative for the investor.

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