Convertible shares or convertible preferred shares are a type of hybrid security that pays a dividend and includes an option for investors to convert the shares into a fixed number of common shares after a specified date. The exchange is usually at the request of the shareholder but there may be a provision that enables the company or issuer to force the conversion.
Convertible shares are valued based on the performance of common stock. Once the common share trades above the conversion price, convertible preferred shareholders may opt to convert their stock to common share. In doing so they give up their rights as a preferred shareholder and become a common shareholder.
How convertible shares work
Companies use convertible shares as a way of raising capital and are popular among early-stage companies. Generally companies raise capital through either debt which must be paid back or through equity which doesn’t have to be paid back. Raising capital using convertible shares falls in between debt and equity on the risk scale.
Convertible preferred shares are a hybrid security that give shareholders a fixed dividend and a claim on assets should the company liquidate, but does not give them the voting rights that common shareholders have. Preferred and common stock will trade at different prices due to their differences. The different types of preferred securities include:
Cumulative preferred
Participating referred
Callable preferred
Convertibles
As a fixed income security, preferred stocks are considered to be less volatile and provide investors with an option to participate in common stock price appreciation. Preferred shareholders benefit from a fixed dividend but the dividend amount does not grow at the same rate as they do for common shareholders.
This means that in a bad market, preferred shareholders are protected with a fixed income, but in a good market they will not benefit from increased dividends or share price. This is usually the trade off when investors chose between preferred or common stock, but convertible preferred shares offer an alternative.
While dividends will be typically lower, preferred shareholders retain the right to participate in share price appreciation. Important factors to take into account with convertible preferred shares include:
Par value: This refers to the face value of preferred stock or the amount payable to the shareholder if the company were to go into liquidation.
Conversion ratio: Set by the company when the preferred stock is issued, this is the number of common shares an investor will receive when they opt to convert.
Conversion price: The price at which convertible shares can be converted into common shares. This is calculated by dividing the convertible stocks par value by the stipulated conversion ratio.
Conversion premium: Sometimes expressed as a ratio, this is the dollar amount by which the market price of the convertible stock exceeds the market value of the common shares they will be converted into.
Advantages of convertible shares
The advantages of convertible shares include:
Protects against risk
Convertible preferred shares are often seen as a less risky investment option as they protect against bad market performance and give preferred shareholders claim to assets if the company were to go bankrupt.
Provides a fixed dividend income
Preferred shareholders benefit from a fixed dividend and therefore have a fixed income making them an attractive and less risky option for risk adverse investors.
Disadvantages of convertible shares
The disadvantages of convertible shares include:
Could miss out on returns
While preferred shares give investors a level of protection against volatility, should the current market value increase it means they will not benefit from increased dividends or share price.
Shareholders will not have voting rights
Preferred shareholders do not typically have voting rights, meaning they have no say in how the company is run. But once they have converted their shares and become a common shareholder they would then have the right to vote.