Preferred Convertible Stock - Explained
What are conversion rights for preferred stock?
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What is Preferred Convertible Stock?
Preferred stock grants special rights above those afforded to common shareholders. Convertible stock allows the preferred shareholder to convert her preferred shares into shares of common stock. There is generally a set or adjustable conversion ratio to calculate the number of common shares resulting from the conversion.
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What are Voluntary Conversion Provisions?
Equity investors often demand preferred shares from the corporation. The most common characteristic of preferred shares issued to equity investors is the ability to convert the preferred shares into common shares. Investors often negotiate for a liquidation preference upon the sale of the company.
This means that the investor receives some multiple of their money invested before the common shareholders receive any money. The investors return on investment may be capped after receiving her liquidation preference, with the rest of the proceeds going to the common shareholders.
At some point, a company may be so valuable that the common shareholder will receive a higher percentage of the proceeds of sale that a holder of a preferred share. In such cases, the preferred shareholder will elect to convert her shares into common shares.
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What are Mandatory Conversion Provisions?
Preferred shares may be subject to mandatory conversion to common shares at some point in the future. Startup ventures intend some form of exit for its owners (all shareholders) at some point in the future. This is normally achieved through acquisition by another company (i.e., a merger) or through an initial public offering (IPO).
In either event, having common at preferred shares at the time of merger or IPO would make the process very difficult. The purchasing shareholders would feel uneasy purchasing common shares when there is a class of preferred shares in existence. As such, to facilitate the merger or IPO process, the preferred shareholder may be forced to convert her shares to common shares at a predetermined time or upon the occurrence of certain events within the startup.
In the event of mandatory conversion, the preferred shares will convert at a ratio that preserves the value of the preferred shares. That is, if there is a liquidation preference, that will be calculated into the conversion price for the preferred shares.