Convertible Preferred Stock: Understanding How It Works

Convertible preferred stock can be traded for a fixed amount of common stock at a given time in the future. Typically, the conversion occurs after a given date. However, the stockholder or corporation may decide to make a conversion at his or their own discretion in some scenarios. Ultimately, the contract and terms to which convertible preferred stock is subject depend on the corporation issuing the stock. 

Common Stock

Common stock is an issuance of equity to a shareholder. The shareholder typically has voting rights to help control his or her equity, and the shareholder will earn money if the value of his or her equity appreciates. This model is the one most commonly thought of when an individual imagines the "stock market." Buying common stock is a means to purchase a part of a company by providing the company with capital.

Preferred Stock

Preferred stock operates in a slightly different manner than common stock. It is more like an issuance of debt combined with an issuance of equity. The shareholder does provide capital in exchange for an equity stake in the company. However, the company promises to pay the shareholder dividends prior to paying dividends to other shareholders. In exchange for this debt payment, the shareholder acquiring preferred stock often surrenders voting rights. The shareholder will still earn money if the value of his or her equity in the company appreciates, but the dividend payment is equally as important as capital gains on the purchase.

Convertible Preferred Stock

Convertible preferred stock is preferred stock purchased with the intention of potentially transferring to common stock in the future. There are a few scenarios in which a company will control when and where the conversion occurs. It is typically based on a date, set when the stock is acquired, and converted based on the value of the stock at the time the conversion occurs. The individual shareholder can typically hold on to the convertible stock past the conversion date. This model is often used with employee stock, and the employer can offer a "stock option" to employees for converting their stock prior to its conversion date. The stock option would present the employer with a chance to remove some obligation to make dividend payments in a given year. 

Benefits of Convertible Preferred Stock

The benefits to a corporation that issues convertible preferred stock are simple. First, it can typically ask a higher price for convertible preferred stock, receiving an immediate influx of capital. Second, it can offer incentives for preferred stockholders to convert the shares in the future if making dividend payments is a challenge. For an investor, convertible preferred stock offers the "best of both worlds." In the present, the investor enjoys dividend payments. In the future, once the stock is converted, the investor holds onto capital appreciation investments. However, the investor pays a premium for these benefits. This is the most flexible class of stocks, and it is priced accordingly. Often, convertible preferred stock can be overvalued, resulting in very little capital appreciation over time.