In this lesson, you will learn about some of the differences between common and preferred stock, with an emphasis on convertible preferred stock issues.
Convertible Preferred Stock
Your business is expanding rapidly and you need to purchase new equipment. Your personal savings are depleted and you have asked the bank to increase your credit line. Unfortunately, the meeting did not go as well as you hoped. The banker was very impressed with your company’s potential but was concerned your company is undercapitalized. In other words, increased debt loads would over-leverage the company and increase its risk profile.
Finding New Capital
Since you do not have additional funds at your disposal, you may look to friends and family for additional investors. Unfortunately, your friends and family may be over-leveraged as well and be unable to provide the capital infusion you need. You were not wild about having a minority shareholder anyway. You like the being the sole owner. In this situation, you will need to use equity financing to raise capital.
Wishing to maintain management control often hinders fundraising for small privately held corporations. Outside investors often want a say in corporate management to protect their investment. Minority shareholders in a private company can be outvoted by the majority shareholder on every vote, so they have no real control over management. Also, there is no easy way for a minority investor to sell his shares since the company is not publicly traded.
The Solution: Convertible Stock
After consulting with your financial advisor, you decide preferred stock is the best way to raise new capital. Preferred stock is somewhat different than common stock. Preferred stock shareholders do not vote to elect directors or in other corporate matters, so management retains control of the company. Preferred stock shareholders receive set dividend payments, somewhat like interest payments for a bond. However, no one can force a board of directors to declare a dividend. If cash flow does not support dividends the board can forego the dividend payment at its discretion. There can be a great variation in characteristics among preferred stock issues. You can attempt to tailor the characteristics of the preferred stock to what makes sense for your company.
Convertible Preferred Stock
A potential investor may require some additional protection and/or additional compensation for his investment by requiring the preferred stock to be convertible. Convertible preferred stock can be exchanged for the common stock of the company if certain conditions are met. The contractually set conversion ratio determines the number of common shares each share of preferred stock may be converted into.
Suppose a preferred stock issue carries a 5% dividend and a $1,000 par. It is also convertible into 100 shares of common stock after two years ($10 per share). This may provide additional protection for the investor if dividends are not declared on the preferred stock. After the conversion, the investor has common stock he may then vote. It is even possible the investor can gain control over the company’s management if he can gather enough of common stock.
The Upside of Common Stock
The investor may also want to participate in the ‘upside’ of common stock. He sees your company has a great deal of promise and hopes you will go public someday. The convertible preferred stock allows him to exchange his illiquid investment for common shares that are hopefully increasing in value as your company grows. In the meantime, the investor is receiving a market rate of return through dividend payments.
The conversion ratio is key to this decision. In this example, the investor will consider converting his preferred stock into common stock when the price of the common exceeds $10. If the investor converts while the common stock has a value of say, $8, he will lose money. If the common stock is trading for $14, the investor stands to make a 40% profit on his investment and receive dividends for the time he held the stock.
The Downside of Preferred Stock
While preferred stock has significant advantages when raising capital, there are some significant disadvantages as well. The dividends on preferred stock are not tax deductible, compared to interest payments on debt. While a board of directors cannot be forced to declare a dividend on the preferred stock, it also cannot pay dividends to the common stockholders until the dividend requirements of the preferred stock have been met.
If you as the business owner are counting on dividends from the company to pay daily living expenses, you may be in for a rude awakening. You may be obligated to pay your investors first, before taking any dividends. Convertible preferred stock has another unique potential downside. The conversion features may impact earnings per share computations if your company becomes publicly traded.
Convertible preferred stock gives an investor a stream of income (dividends on the preferred stock) as well as potential ‘upside’ advantages. It can be converted into the common stock of the company at the predetermined date and conversion ratio. Investors find this to be an attractive feature of a preferred stock. If the company is doing extremely well, the preferred shareholders can convert their stock into common stock, taking advantage of the rise in the common stock price.