Convertible Preferred Stock

Convertible preferred stock (known as preference shares in the United Kingdom) gives the holder the right to
exchange it at a fixed price for another security, usually common stock. The trick is knowing if, and when, to
exercise that right.

Getting Started
• Evaluating convertible preferred stock is principally an analysis of risk rather than of a company.
• Preferred stocks are listed as equity on a balance sheet, but they perform more like bonds than
common stock since most of these issues pay a fixed dividend set at the time of issue.
• While holders of preferred stock are entitled to a fixed dividend, they do not usually have voting rights.
• Preferred stocks are usually repayable at par value, and rank above the claims of ordinary
stockholders but behind bank and trade creditors.
• An expensive form of capitalization, preferred stock is typically used to finance growth opportunities
and capital expenditures, and to repay bank debt and nonbank short-term debt.
• Preferred stocks are often preferred by venture capitalists because they protect their investments
better, and offer them greater leverage and growth opportunities.
• US income tax considerations severely limit the appeal of preferred stock among individual investors,
but enhance it among corporations.

FAQs

Officially, what is convertible preferred stock?

It is a share of corporation ownership that gives holders a claim prior to the claim of common stockholders on
earnings and, generally, on assets in the event of liquidation. It may also be exchanged for a fixed number of
shares of common stock. Because no maturity date is stipulated, preferred stock is priced based on a stated
dividend yield—in, for example, dollars, pounds, or euros—or as a percentage of par value.

How does preferred stock compare to common stock?

The dividend on common stock is uncertain and variable: high when a company performs well, low or
nonexistent when it fares poorly. Holders of preferred stock, however, get a fixed dividend—and one which,
if not paid, accrues until it can be. On the other hand, preferred stockholders are not usually able to vote
on pertinent resolutions unless dividends fall into arrears, while holders of common stock have voting rights
based on the number of shares owned.

Are there different kinds of preferred stock?

Yes. For example, callable preferred stock may be repurchased by the issuing company, typically at par
value or slightly higher, while an indirect convertible may be exchanged for another convertible security,
such as a bond that can be exchanged for convertible preferred stock. There are also participating preferred
stocks, which entitle holders both to receive specified dividends and to participate along with holders of
common stock in receiving additional dividends.

Any there other important distinguishing features of preferred stock?

First, there may be an option to receive cash for those who decline to exercise their conversion rights. Most
preferred stocks also carry lower interest rates than similar fixed-interest securities, since the investor has
the opportunity to convert his holdings to common stock and, in turn, to realize a capital gain if its price rises
above its conversion price. Some preferred stocks also permit the investor to require the issuing company to
redeem the stock after a predetermined time for an amount that gives the investor a modest profit.

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Venture capitalists are known to prefer preferred stock. Why?
It gives them preference in the event of a company’s liquidation or sale, which enables venture capitalists to
get back their investment before other investors receive any proceeds from such events. A typical convertible
preferred stock also enables venture capitalist investors to convert their shares into common stock according
to a predetermined formula and to vote on major stockholder issues such as the election of directors and a
change of the company’s core business activity.

How are repeated conversions of preferred stock prevented from diluting the value of
common stock?
The formula used to convert the convertible preferred stock into shares of common stock typically includes
an adjustment mechanism—an “anti-dilution provision”—that protects the investor against any dilution in
his percentage ownership caused by sale of cheaper stock to later investors. The nature and extent of the
protection afforded can be very important also to the holders of the company’s common stock: the greater
the protection against dilution given to the holder of convertible preferred stock, the more dilution common
stockholders are likely to suffer

Making It Happen
Like almost any stock consideration, evaluating convertible preferred stock opportunities and transactions is
based on research, market knowledge, and past experience.
It is essential first to understand what a company does and how it generates cash. The next question is
determining the likelihood of the company being able to pay its preferred dividends. The tools of choice are,
first, a common “coverage ratio” like EBIT or EBITDA, and, second, preferred stock ratings.
EBITDA is the acronym for “earnings before interest, taxes, depreciation, and amortization.” It usually
measures a company’s ability to handle debt service (interest payments), but can easily be adapted to
include preferred stock dividends. The ratio is:
EBITDA ÷ (Interest expense + Preferred dividends)
The higher the coverage ratio, the better.
Like corporate bonds, most preferred stocks are rated by such services as Standard & Poor’s and Moody’s.
Each rating service uses a slightly different rating system, but they have a similar basis: “A” is good, “AAA”
is better, and so on. A “B” or above is considered investment grade, but anything below that is regarded as
very high risk.
Another warning point is that, if a preferred stock is rated only by one of the second-tier rating agencies, the
likelihood is that the company’s management was unable to get a favorable rating from Standard & Poor’s or
Moody’s. The investor relations offices and websites of most corporations will provide the ratings. If they do
not, beware—although the websites of the rating services themselves will probably list them.
There are also some guidelines to follow. For instance, preferred stocks should have a higher yield than the
issuing company’s comparable debt (yield is the annual dividend divided by the price). This must be gauged
on a case-by-case basis.
There is another long-held contention that higher-quality companies issue standard convertible preferred
stock, while lower-quality companies issue convertible exchangeable preferred stock. Similarly, it is
maintained that only the “best” companies are consistently able to issue straight debt cost-effectively, while
medium-quality companies issue convertible securities, and lower-quality companies or high-risk companies
tend to issue additional common stock.
Conversion ratios and prices are other key facts to know about preferred stock. This information is found on
the indenture statement that accompanies all issues. Occasionally the indenture will state that the conversion
ratio will change over time. For example, the conversion price might be $50 for the first five years, $55 for the
next five years, and so forth. Stock splits can affect conversion considerations.

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In theory, convertible preferred stocks (and convertible exchangeable preferred stocks) are usually perpetual
in time. However, issuers tend to force conversion or induce voluntary conversion for convertible preferred
stock within 10 years. Steadily increasing common stock dividends is one inducement tactic used. As a
result, the conversion feature for preferred stocks often resembles that of debt securities. Call protection for
the investor is usually about three years, and a 30- to 60-day call notice is typical.
About 50% of convertible equity issues also have a “soft call provision.” If the common stock price reaches
a specified ratio, the issuer is permitted to force conversion before the end of the normal protection period.
Converting preferred stock risks diluting common stock, of course, and among mature companies that is
a valid concern. Where a company has a good track record and aggressive growth plans, however, it may
benefit both investors and the company, especially if the management can maintain (or increase) profit
margin.

Tricks of the Trade

• In any country, tax considerations invariably accompany the exercise of convertible preferred stock
transactions. Here are considerations based on US laws:
• Like common stock, preferred stock comes with a prospectus that should answer such basic questions
as: Are the dividends cumulative? Are the shares redeemable; if so, when? What is the likelihood
of redemption? Has the board of directors ever suspended dividends? (If it has, this is a bad sign
indicating cash flow problems).
• At least in the United States, many companies dislike issuing preferred stock because it is an
expensive form of capitalization. Preferred stock pays dividends from after-tax profits, while bonds pay
interest from pre-tax dollars, thus delivering a tax break that preferred stock cannot match.
• Owning preferred stocks of other companies is another matter, however: corporations are exempt from
taxes on up to 80% of preferred dividend income.
• Missing preferred stock dividends is not legally a default, but a company that omits a preferred stock
dividend may not pay common stock dividends. Moreover, if subsequent preferred stock dividends are
missed, preferred stock shareholders may gain board seats (or more of them), and in some cases also
accrue special voting rights.
• Most preferred issues are cumulative, so dividends accrue even if they are not actually paid in a given
quarter. Once the dividends are resumed, and before common dividends can be paid, cumulative
preferred shareholders must be paid their accrued dividends.
• If a company is liquidated, holders of preferred stock are entitled to receive their investment back
before the holders of any common stock receive anything. In other words, “investment” means
the amount paid for the preferred stock plus any accrued and unpaid dividends—an important
consideration.
• Preferred stocks and other convertible securities offer investors a hedge: fixed-interest income without
sacrificing the chance to participate in a company’s capital appreciation.
• When a company does well, investors can convert their holdings into common stock that is more
valuable. When a company is less successful, they can still receive interest and principal payments,
and also recover their investment and preserve their capital if a more favorable investment appears.

More Info
Book:
• Jenks, Philip, and Stephen Eckett. The Global Investor Book of Investing Rules. London: Harriman
House, 2001.

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