is convertible preferred stock debt or equity

Full Answer

What is preferred stock and convertible debt?

Preferred stock and convertible debt agreements are the foundational agreements that startup investors use to structure their investments. Each structure has pros and cons, and both are commonly used in seed financing. The terms of the arrangement, your startup’s needs, and the preferences of your potential investors should ultimately guide your ...

What is investor influence?

Investor Influence – Under a convertible debt arrangement, incoming capital providers do not receive influence over management decision making. Unlike preferred stockholders, convertible debt holders do not receive a board seat and management does not need bondholder approval for key decisions.

What is preferred stock agreement?

Legal Costs – Preferred stock agreements involve extensive drafting of legal documents that outline investor rights. Convertible debt agreements are much cheaper to execute, allowing the startup to invest the cost savings back into the business.

What is convertible debt?

Convertible debt arrangements allow investors to loan a startup money with debt that converts into equity at a future date. Like traditional loans, convertible debt agreements include a principal amount, an interest rate and a maturity date. Since many startups lack the funds to support cash interest payments, most convertible debt agreements allow the interest to accrue until the maturity date (or conversion date). When the startup raises an equity round, the principal amount and any accrued interest automatically convert into equity (normally preferred stock).

What happens to preferred stockholders in liquidation?

In the event of a liquidation, preferred stockholders and convertible debtholders are entitled to recoup the full amount of their investment before common stockholders receive any of the proceeds. This is commonly referred to as having seniority 1 over common stockholders (who are usually the startup’s founders and employees).

What are the advantages of convertible preferred stock?

What are the advantages of issuing convertible preferred stock during seed financing? 1 Certainty about Valuation – Preferred stock arrangements attach a valuation to the overall company and each share price, providing clarity about how much the startup is worth. Convertible debt arrangements do not attach a valuation to the startup, causing the company’s various stakeholders to have differing opinions about the company’s value. 2 Certainty about Ownership – After a preferred stock deal, all investors understand the exact structure of the cap table 6. In convertible debt arrangements, the structure of the cap table may be unclear until an equity round has been completed and the debt has converted to equity. 3 Preparation for Future Fundraising – Participating in preferred stock negotiations while raising seed financing can prepare you for later financing rounds where the stakes are even higher. Negotiating the valuation for an equity round and setting up the terms of a deal require judgement, skill, and diplomacy. You will not develop these skills as fully in a convertible debt deal because decisions about the most contentious points are deferred until a Series A round. 4 Investor Preferences – Some angel investors will only invest in preferred stock deals. Issuing preferred stock instead of convertible debt may be your only means of attracting certain investors.

What is anti-dilution provision?

Anti-dilution Provisions – Anti-dilution provisions protect investors from losing value in subsequent financing rounds by adjusting the price at which preferred stock converts to common stock.

What is Convertible Preferred Stock?

Convertible preferred stock is a type of preferred stock that gives holders the option to convert their preferred shares into a fixed number of common shares after a specified date. It is a hybrid type of security that has features of both debt (from its fixed guaranteed dividend payment) and equity (from its ability to convert into common stock ).

What happens when you convert preferred stock to common stock?

When convertible preferred stock holders choose to convert their stocks to common stocks, the stocks they receive are newly issued. This increases the total number of common shares. Because the number of common shares increases while the value of the company remains the same, the value of existing shares goes down.

What happens if a convertible preferred shareholder converts to common stock?

However, if a convertible preferred shareholders converts to common stock, then the company’s obligation comes to an end. This is because companies have no obligation to ever pay dividends to common stock holders. Some agreements allow companies to force investors to convert their shares.

How does conversion premium affect the price of convertible preferred shares?

The conversion premium influences the price of convertible preferred shares traded on the market. The market price of convertible shares will tend to rise and fall with the price of the company’s common shares when the premium is low. When the premium is high, the convertible shares market price tends to track interest rates, rising when interest rates fall, and falling when interest rates rise.

What is a conversion ratio of 5?

A conversion ratio of 5 means they get 5 shares of common stock for every of convertible preferred, a conversion ratio of 6 means they get 6 shares, and so on. For the investor to make money on this exchange, the common shares have to be trading at a price greater than the purchase price of a share of the preferred common stock divided by ...

How many shares of common stock do you get for every convertible preferred?

However, if the common stock prices are rising, the investors can do even better. They can exchange their convertible shares for common shares and get six common shares for every share of convertible preferred they own, based on the conversion ratio. A conversion ratio of 5 means they get 5 shares of common stock for every of convertible preferred, a conversion ratio of 6 means they get 6 shares, and so on.

Why do convertible preferred stock holders get lower dividends?

This is because the convertible holders have received something of value -- their ability to convert their stocks. To compensate, the dividend rate may be lowered.

What Are Convertible Preferred Shares?

These shares are corporate fixed-income securities that the investor can choose to turn into a certain number of shares of the company's common stock after a predetermined time span or on a specific date. The fixed-income component offers a steady income stream and some protection of the invested capital. However, the option to convert these securities into stock gives the investor the opportunity to gain from a rise in the share price .

What is convertible stock?

Convertibles appeal to investors who want to participate in the stock market without feeling as though they are taking wild risks. The securities trade , like stocks, when the price of common shares moves above the conversion price. If the stock price slips below the conversion price, the convertible trades just like a bond, effectively putting a price floor under the investment.

What is the conversion ratio of Acme?

The conversion ratio shows what price the common stock needs to be trading at for the shareholder of the preferred shares to make money on the conversion. This price, known as the conversion price, is equal to the purchase price of the preferred share, divided by the conversion ratio. So for Acme, the market conversion price is $15.38 or ($100/6.5).

How does interest rate affect convertible preferred shares?

That means that interest rates, too, can impact the value of convertible preferred shares. Like the price of bonds, the price of convertible preferred shares will normally fall as interest rates go up since the fixed dividend looks less attractive than the rising interest rates. Conversely, as rates fall, convertible preferred shares become more ...

What happens if you buy Acme shares?

By buying Acme convertible preferred shares, the worst investors would ever do is receive a $4.50 annual dividend for each share they own. But these securities offer the owners the possibility of even higher returns. If the convertible preferred shareholders see a rise in Acme's stock, they may have the opportunity to profit from that rise by turning their fixed-income investment into equity. On the reset date, shareholders of Acme convertible preferred shares have the option of converting some or all of their preferred shares to common stock.

How are convertible preferred shares determined?

Convertible preferred shares can be sold on the secondary market, and the market price and behavior are determined by the conversion premium, which is the difference between the parity value and the value of the preferred shares if the shares were converted.

What happens when a preferred shareholder converts their shares?

After a preferred shareholder converts their shares, they give up their rights as a preferred shareholder and become a common shareholder.

General Context

• Why do investors use convertible preferred stock and convertible debt instead of common stock?
  Startup investors shoulder significant risk by financing new, unproven businesses. While they hope that their portfolio companies will grow and provide large returns, investors strive to implement protections that reduce risk in case a startup performs poorly. Both preferred stock a…

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Convertible Preferred Stock

Convertible Debt

Conclusion

Resources Consulted

Footnotes

Overview

• While buying stocks always poses the risk of losing money, avoiding stocks altogether means m…
  In this article, we'll cover what these securities are, how they work, and how to determine when a conversion is profitable.
• Convertible preferred shares can be converted into common stock at a fixed conversion ratio.
  Once the market price of the company's common stock rises above the conversion price, it may be worthwhile for the preferred shareholders to convert and realize an immediate profit.

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What Are Convertible Preferred Shares?

How Convertible Preferred Shares Benefit Investors

How the Conversion Ratio Works

Understanding the Conversion Premium

The Bottom Line