Summary - When companies want to raise capital they have two options. One is to take on debt and the other is by offering an equity stake to investors through issuing shares. However, not all shares are the same. The shares that are most widely discussed are called common shares. These are publicly traded on one of the major stock exchanges and the prices are set by the market. But there are occasions for a company to issue a different class of shares called preferred shares (also called preference shares). Preferred shares can come in many different forms, depending on their objective. One of the more common types of preferred shares are convertible shares. Convertible shares are sold to investors with a PAR value (like a bond) that is substantially higher than what there common stock price per share may be. Issuing convertible shares is also a technique used by startup companies as a way to raise revenue.
In return for the higher initial investment cost, the investor is given a dividend yield that, unlike dividends offered to common shareholders, is guaranteed even if the company runs into financial trouble and has to liquidate. But, unique to convertible shares is the opportunity for investors to convert their preferred shares to common shares at a fixed date. To account for the difference in share price, investors are given multiple common shares for every convertible share they own. The number of common shares to preferred shares is called the conversion ratio. A ratio of 5 means that an investor would be entitled to receive five common shares for every preferred share they owned.
Convertible preferred stock can be purchased just like shares of common stock and there are even mutual funds, such as a convertible securities fund, that allows investors to spread their risk across many different companies. However, an investor should pay close attention to the prospectus for each fund as most will invest in convertible bonds as well as stocks. Convertible bonds behave differently from convertible preferred stock.
Introduction
“Past performance does not guarantee future results”. It’s a disclaimer that every investor has come to know. It’s almost to the point where they pay little attention to it. However, any investor that has been stung by the misfortune of a “can’t miss” start-up or “the next Amazon” that turned out to be, well … not so much … will tell you that there is no such thing as a sure thing. Still, there are many companies that show great promise and need to raise revenue to take their business to the next level. If an investor wants to take a chance on that company, but protect themselves (as much as possible) from the potential for downside risk, convertible shares may be the way to go.
Convertible shares are a preferred share offering that companies issue as a way of generating revenue without taking on debt. These preferred shares offer investors a fixed dividend rate with the opportunity to convert their preferred shares to common shares at a future date.
In this article, we’ll take a closer look at convertible shares and go into detail about how they are different from common shares, why companies would choose to issue them and what are some of the risks involved, how the conversion ratio works and how a convertible share is different from other convertible financial instruments.
What are convertible shares?
Convertible shares are a class of a company’s preferred shares. Like common shares, convertible shares give shareholders an ownership stake in the company that is offering the shares. They are considered to be a hybrid equity because they have elements that offer the income generation of a bond and the potential for growth that defines an equity instrument.
Convertible shares are purchased at a PAR value that is similar to a bond, but offer investors an initial fixed rate of return via a guaranteed dividend and provides the opportunity for investors to realize capital appreciation by converting their preferred shares to common shares at a later date.
Investors need to ensure that the preferred shares they are purchasing are convertible shares. There are many classes of preferred shares. The relationship between preferred shares and convertible shares can be summed up like this. All convertible shares are preferred shares but not all preferred shares are convertible shares. With that in mind, for the rest of this article, we will use the term convertible shares and preferred shares interchangeably.
What is the difference between common shares and convertible shares?
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Convertible Shareholders
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Common Shareholders
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Have a stated preference amount in the event of liquidation (such as in a bankruptcy filing)
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Yes
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No
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Dividend payment
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Set rate
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Not set rate
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Have voting rights
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No
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Yes
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Higher upside growth potential
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No
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Yes
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The primary difference between shares of common stock and shares of preferred stock is in how the shareholders are prioritized should a company have to liquidate assets, which can happen due to a restructuring or, more likely, a bankruptcy filing. In the case of preferred stock, owners will receive a stated preference amount to recapture their investment in the company. In many cases, common shareholders will not be able to recoup any of their investment.
Also, only owners of convertible, preferred stock are guaranteed to receive a dividend at a set rate. Offering a fixed income component is one way that preferred shareholders are provided with an incentive. Owners of common stock are not guaranteed a set dividend rate and are not assured of receiving a dividend at all, even if they were a shareholder of record by the ex-dividend date. When interest rates are low, this is a benefit to preferred shareholders. However, if interest rates were to rise, the guarantee of a preferred dividend rate may not be as compelling.
On the other hand, preferred shareholders will most likely not be issued voting rights for their convertible shares like common shareholders. While it’s rare for any single common shareholder to own enough shares to give their vote significant influence over a company’s actions, it is a right that is offered to common shareholders. Also, preferred shareholders – at least initially – forfeit the opportunity for the upside growth that owners of common stock can enjoy.
However, while investors may forfeit potential gains, they are also shielded from potential losses. This is one reason why convertible shares are considered the best of both worlds for investors regardless of their risk tolerance. If they are unsure about a company’s fortunes, owning convertible shares gives them guaranteed income through the dividend and the potential to convert into common shares to enjoy gains if the stock begins to grow. To understand when a convertible shareholder may find it beneficial to convert to common shares requires understanding the conversion ratio which we’ll review next.
What is a conversion ratio?
The conversion ratio defines the number of common shares an investor will receive for each share of preferred stock they own if they choose to convert them. The conversion ratio is set at the time the convertible shares are purchased and allows investors to set the conversion price. For example, a conversion rate of 3 means that an investor will receive three shares of common stock for each preferred share; a conversion rate of 5 means the investor will receive seven shares of common stock for each share of preferred stock.
The conversion ratio is also important for determining the stock price that the common shares must reach to make a conversion profitable. For example, if an investor owns 100 shares of preferred stock and the conversion rate is four then they would divide the number of shares they own by four. So in this case: 100/4 = 25.
This means the conversion price for exchanging shares of preferred stock into common stock will be $25 per share. Note that to reach the profit point we’re not concerned with how much money the investor paid to acquire his preferred shares. The assumption is that the conversion ratio will mean that the investor will make a profit.
In our example, let’s say our investor had paid $100 each for their 100 shares. Their investment would be $10,000. If the market price of the common stock rises to $28 and the investor decides to make the conversion, they would then receive 400 shares valued at $28 for an investment that is now worth $11,200. They paid nothing extra and have pocketed a $1,200 gain.
And as we mentioned earlier, the option to hold a convertible stock can shield an investor from downside risk. If the common stock of the company in our example above dropped to $20 per share, the investor would be looking at a loss of $2,000 (20 x 400 = $8,000). With that being the case, the investor would likely choose to hold onto the preferred stock and still collect the fixed income benefit of a guaranteed dividend rate.
Why do companies issue convertible shares?
Convertible shares are a way for a company to raise capital on better terms than they can get through equity financing. When a company has what is called an issuance of shares, it dilutes the value of any existing shares. This can be problematic if a company already has a low stock price. An issuance of preferred shares is a way for a company to borrow money at a lower interest rate than with traditional debt financing (such as a loan). And by offering a generous dividend, they can sell shares at a higher price than traditional common shares.
However, a company may also seek to issue preferred shares because they have poor credit and have no way of obtaining additional financing. This can make these companies a higher default risk which is a factor that investors will have to balance when deciding whether to invest in the company. One way for investors to guard against this risk is to ensure that the convertible shares receive a positive rating from one of the major rating agencies (i.e. Standard & Poors, Moody's, etc.). If they cannot receive a positive rating from a major agency further research should be conducted to determine why that is the case.
In addition to the risk of default, investors should take care to read the prospectus very carefully before investing in preferred shares. This is because companies can set their own rules about when preferred shares can be converted and if conversion is mandatory.
How are convertible shares different from other convertible financial instruments?
Convertible shares are a form of convertible equity that is different from convertible debt instruments such as a convertible note. The latter is a loan that a venture capitalist (otherwise known as an angel investor) will provide with the promise that their investment will be converted to equity once the company completes some form of financing. A convertible note usually features a valuation cap that essentially assigns a floor for the venture capitalist. Convertible shares, on the other hand, are considered a form of convertible equity and are generally considered to be more friendly to start-up companies because it removes any question about future valuations. This is one reason why many start-up companies strongly prefer offering convertible shares when seeking venture capital.
Convertible shares are also different from convertible bonds. Like convertible bonds, convertible shares have a par value. However, convertible bonds have an interest rate and maturity date. Convertible shares, on the other hand, have a defined preference amount should a company liquidate and, in place of a bond's coupon rate, feature a set dividend rate.
The final word on convertible shares
Convertible shares are a form of preferred shares that companies offer as a way of raising significant amounts of capital without having to take on debt. In exchange for charging a PAR value per share that is substantially higher than what an investor would pay for common shares, the issuing company will offer investors the assurance of a guaranteed dividend rate that acts as a hedge against any potential downside movement of the stock and the option to convert their shares to common shares at a pre-determined conversion ratio. If the conversion price is favorable to investors, it gives them an opportunity to participate in the upside potential of a stock.
Convertible shares are only one type of preferred share, and not all preferred shares fall into the category of convertible shares. Investors should also pay particular attention to what rating, if any, a major agency gives to the preferred shares. Some companies cannot obtain conventional financing and so issuing convertible shares are their only option to raise revenue. This increases their default risk which is something an investor will have to balance when considering whether or not to invest in the company.
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