A convertible security is a financial instrument that can be exchanged for a certain number of shares of a company’s common stock at some future time. A convertible security typically is preferred stock but can also be a corporate bond. Companies issue convertible preferred stock because it commands a higher price, which means the company raises more capital than if it issued the same number of common shares.
Investors who buy convertible preferred stock typically collect a larger dividend than those who buy common stock, but in return preferred shareholders give up their right to vote on corporate governance issues. Also, all preferred shareholders get priority claim on any dividend payouts. Common stock owners don’t get any dividends until all preferred shareholders have been paid. Preferred stock prices go up and down but to a much lesser extent than the price of common stock. Investors with convertible preferred stock get the best of both worlds. They collect hefty dividends while holding preferred shares but can convert them to common stock if they believe the company’s common stock is in for a big price rise.
The company can set the terms of the conversion. It can allow preferred holders to obtain a fixed number of common shares for each convertible preferred share. A fixed conversion rate may include a cap on the number of shares you can convert at any one time. The potential problem with fixed-rate conversions is dilution of common stock. Conversions create new shares of common stock that are added to the number of shares already outstanding, which reduces earnings per share and proportional ownership.
A company may also base the conversion on the common stock’s market price as of the date the convertible preferred shareholder chooses to do the conversion. If the market price of the common stock goes down, the convertible preferred share owner gets more shares of common stock for his preferred stock. This protects preferred shareowners from common-stock price drops. The downside for the company is that drops in the common stock’s market price may encourage conversions. As prices drop, the company must issue more and more common shares to satisfy conversions of preferred stock. This further dilutes the common stock, to the detriment of the company and its common shareholders.
Before buying convertible preferred stock, investors should be sure they fully understand how the conversion formula works, the potential effects of conversions on common stock prices and how those effects can alter the conversion formula. Companies issuing convertible preferred shares should make sure they understand not only the potential impacts of conversions on their share prices but also how conversions can affect their ability to obtain non-equity financing.