January 26, 2022

Accounting + Finance Blog

# Meaning of Convertible Preference Shares and Key Explanations

Preference shares are fixed income or passive income that are less risky when compared with ordinary shares. To make it more mouth watering is a special kind of it known as convertible preference shares. In his article, the definition and key explanations of this stock will be discussed.

### Definition of Convertible Preference Shares

It is a type of preference shares that entitled the holder not only to a fixed dividend but also to convert the shares to ordinary ones at a predetermined time or a specific date. The shares are inverted based on a conversion ratio and the shareholder may earn capital gain in addition to its fixed income.

### Key Explanations

A type of preference shares. There are other types of preference stock in addition to the one under discussion. All of them have similar features with a particular difference. For example, a cumulative preferred stock is mainly when the holder can accumulate its fixed income. The dividend can be accumulated for many periods until when the company earns enough profits to pay them off.

Fixed dividend. The shareholders are entitled to a fixed income. This means that he or she knows the income to receive yearly on the shares. The dividend is at a fixed rate. If he has 10,000 shares at 15 Naira per share and the rate is 5%. It means that his income shall be 5% × N15 × 10,000 shares. This will give N7,500.

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Conversion ratio. In addition to the major features a conversion ratio is attached to these shares. The ratio is the rate at which the preference shares will be converted to common stock. The agreement may be to convert 5 preference shares for 1 ordinary. In the above example, it means that the holder will get 10,000 divided by 5 ordinary shares. Or 2,000 common shares.

Note that ordinary shares and common shares are synonymous. The conversion ratio comes with a conversion price. The conversion price in the example shall be 3 Naira. That is, 15 divided by the conversion ratio which is 5 (15 ÷ 5). The shareholder in the above example, will have N6,000 Naira worth of common shares (that is, 2,000 shares multiplied by N3).

Predetermined time or specified date. The conversion date may be stated in the shares certificate. Or may be determined later on by the investors or board of directors. The date is very critical as it may affect the market price of the shares after conversion. After conversion, the investors expect the market price to be higher than the conversion price. If this happens, they earn capital gains. However, if the opposite occurs, the shareholders suffers capital loss and it would have been better not to convert the preference shares.

### The Benefits of Convertible Preference Shares

There are four benefits.

Firstly, the holder enjoys fixed income. And such income is paid before ordinary shareholders. If the company makes profits that cover fixed dividends but cannot pay variable income, then only preferred stockholders are paid for that year.

You may like to read: Meaning of NonCumulative Preference Shares with Key Explanations

Secondly, when the shares are converted, the investors will get variable dividends enjoyed by common stockholders. Most times these dividends are higher than fixed income because the risk involved is more compared to preference shares.

Thirdly, in the event of liquidation, preference shareholders have a refund of the capital before ordinary shares. This makes this type of shares less riskier than common stocks.

Finally, after conversion of the shares to ordinary ones, the holder may benefit from capital gains if the price skyrockets. In the example above, if the price increases to 7 Naira. The capital gain per share shall be 4 Naira. That is the market price of 7 Naira minus the conversion price of 3 Naira.

### Disadvantages of Convertible Preference Shares

One disadvantage is that the investors may make capital loss after conversion, if the market value falls below the conversion price. In such case, the investors may not sell its shares unless, if it is willing to incur the loss.

Another disadvantage is that convertible Preference shares do not have voting rights as long as it remains a preferred stock. Furthermore, the fixed dividend received may be small when compared to what ordinary shareholders were paid at the end of every year. Lastly, the investors will suffer if the company liquidates within a short time after the conversion.

### A model for venture capitalist

Convertible preference shares are a good model for venture capitalists (VCs). Venture capital firms invest in small companies with high growth potential. And after such investments, the aim is to find a good exit from the company. The investors of a VC can exit by converting the preference shares to ordinary shares. Then list the shares in a reputable stock exchange market at a market price higher than the conversion price so that the investors may earn capital gain if they decide to sell their shares.

### Conclusion

A convertible preference share goal is to change such stock to ordinary shares. Upon conversion, the investors expect the price to rise above the conversion or par value of the shares in order to earn capital gains. These shareholders may suffer most if the price falls below the conversion price or the company liquidates within a short time after conversion.

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