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What is Convertible Preferred Stock?

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The Daily Ledger · Markets

When the company went public, its convertible preferred stock switched into ordinary shares, and the investors' right to be repaid first out of a sale ended with it.

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Overview

Convertible preferred stock is a type of share that gives its holder special rights and can be swapped for a set number of ordinary shares. The special rights come first. In a startup, the main one is that if the company is sold, the holder gets a fixed amount of money back before the ordinary shareholders get anything. In a listed company, the shares usually pay a fixed dividend as well. The swap is the second part. Each preferred share can be turned into a set number of ordinary shares, and once that is done, the special rights are gone. The holder swaps when the ordinary shares are worth more than the special rights. Otherwise the holder keeps the preferred shares.
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Overview

Convertible preferred stock gives an investor a fixed payout now and the option to swap into ordinary shares later. Berkshire Hathaway's 2009 Dow Chemical deal shows both halves. Berkshire paid $3B for preferred shares that paid 8.5% a year, which is $255M. Each preferred share cost $1,000 and could be swapped for 24.201 Dow shares. Those 24.201 shares beat the $1,000 only when Dow trades above $41.32, so below that price the swap made no sense. Until then, the dividend kept landing. The catch: Dow wrote in its own exit. From 2014, if its stock stayed above $53.72 for 20 of 30 trading days, Dow could force the swap and stop paying the $255M. 😎

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Detail

Convertible preferred stock is a share with a built-in choice: keep the special rights it carries, or turn it into a set number of ordinary shares. The special rights depend on the company. In a startup, the main right is that if the company is sold, the holder gets a fixed amount of money back before the ordinary shareholders get anything. In a listed company, the shares usually pay a fixed dividend as well. These shares are not a loan: the company owes no interest and has no date to pay the money back. The swap rate is written into the shares when they are issued. Each preferred share can be turned into a set number of ordinary shares, and that number changes only if the contract says so, for example after a stock split. The holder cannot have both. Swapping ends the special rights. So the holder compares the two. Suppose an investor paid $5M for preferred shares in a startup, and the deal set the swap at a number of ordinary shares equal to 25% of the company. If the company is sold for $16M, 25% would be $4M, so the investor keeps the preferred shares and takes the $5M back. If it is sold for $40M, 25% would be $10M, so the investor swaps. At $20M the two are equal, because $5M is 25% of $20M. The numbers change from deal to deal, but the test is the same: swap when your share of the company is worth more than the fixed amount. The holder does not always get to choose the moment. In startups, the shares usually swap on their own when the company lists on a stock exchange in a large enough offering; Chegg set that at $30M raised. In listed companies, the company can often force the swap once its share price has stayed above a set level for a set number of days. Either way, the swap is final. From then on the holder has ordinary shares only.
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Detail

Convertible preferred stock hands the holder two things: special rights now, and a swap into ordinary shares at a rate locked in on day one. In a listed company, the rights tend to mean a fixed dividend and a place ahead of ordinary shareholders if the company is wound up. In a startup, the headline right is getting your money back first when the company sells, and the swap tends to happen by itself if the company goes public. The locked rate is the whole point. If the ordinary shares climb, the swap is worth more. If they sink, the dividend is still there. Warren Buffett's 1989 Gillette deal is the clean example. Berkshire put in $600M for shares paying 8¾%, about $52.5M a year, swappable at $50 each, which works out to 12M Gillette shares. In early 1991 Gillette called the shares in, and that April Berkshire swapped them for the 12M shares. The swap kills the dividend, and it does not come back. Buffett warned his shareholders the switch would cut Berkshire's reported earnings by about $35M a year, because the 12M ordinary shares paid a far smaller dividend than the $52.5M the preferred had paid. Same playbook, different ending: Berkshire's $358M of USAir preferred, swappable at $60, sat well below cost by the end of 1990, by Buffett's own reckoning. There the swap was worth little, and the dividend was what Berkshire had left to lean on. And once you swap, there is no swapping back. 😎

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Analogy

A smoothie chain lets a new shop use its name, and nobody knows yet how much the shop will sell. So the contract pays the chain a flat $30K a year, however much the shop sells. The contract also has a switch. Once the shop sells more than $500K in a year, the flat fee stops for good, and the chain takes 6% of sales instead, even if sales fall later. At $500K the two are equal, because 6% of $500K is $30K. Below that, the flat fee pays the chain more. Above it, the 6% pays more. The flat fee plays the part of the special rights. The 6% plays the part of the ordinary shares. The switch that cannot be undone plays the part of the swap. Where the picture breaks: the chain gets a share of sales, not a share of the shop. The flat fee is a bill the shop owes, and preferred shares are not a bill. And here the contract flips the switch, while the holder of convertible preferred can usually choose.
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Analogy

You invent a clever phone stand and license it to a maker, and no one can say whether it will sell. So the deal guarantees you $20K a year no matter what, plus a one-time button: trade the guarantee for 5% of turnover. Press it and the $20K is gone forever. The maths is simple. 5% beats $20K once turnover tops $400K. Turnover hits $1M? Press it, that's $50K. Turnover stalls at $150K? Keep the guarantee, because 5% would get you $7.5K. The guarantee stands in for the special rights, the 5% for the ordinary shares, and the button for the swap. Where it falls short: you get a cut of turnover, not a slice of the company. And the button is yours alone, while a company can often force the swap on convertible preferred holders. 😎
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Formal definition β€” The same term, explained the usual way

Convertible preferred stock is a class or series of preferred stock whose holders may exchange each share for a number of shares of common stock, calculated as the original issue price divided by the conversion price then in effect. Until conversion the shares carry the preferences set out in the certificate of incorporation or certificate of designation, which in venture financings is chiefly a liquidation preference and in listed issues typically also a fixed dividend. Conversion may be at the holder's option, automatic upon a qualified initial public offering or a vote of the class, or at the issuer's election once the common stock has traded above a specified price for a specified period. Upon conversion the preferential rights terminate, and the conversion price is adjusted for stock splits and, where the terms so provide, under anti-dilution provisions.

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