Automatic conversion: Overview, definition, and example
What is automatic conversion?
Automatic conversion refers to the process by which a financial instrument, such as a convertible bond, preferred stock, or other securities, is automatically converted into another form of equity or financial instrument without the need for manual intervention or explicit action by the holder. This process often occurs under predefined conditions specified in the contract, such as a specific date, triggering event, or a certain value or ratio.
In many cases, automatic conversion is used to convert debt into equity, allowing the issuer to reduce its debt burden and give the holder shares in the company. This type of conversion is common in venture capital agreements, convertible notes, or preferred stock agreements.
Why is automatic conversion important?
Automatic conversion is important because it provides a streamlined and efficient way for securities or debt to be converted into equity without requiring additional action from the holder. It simplifies the conversion process and ensures that it happens under clearly defined conditions, reducing the risk of delays or disputes.
For companies, automatic conversion can be a tool to manage debt, dilute ownership proportionately, and facilitate capital raising. For investors, automatic conversion can provide a way to convert their investment into company shares, often at a favorable rate or timing, while avoiding the need to manually convert the securities.
Understanding automatic conversion through an example
Imagine an investor purchases convertible bonds from a startup company. The bond agreement specifies that, after a set period of time (e.g., three years) or upon reaching a specific milestone (e.g., a funding round), the bonds will automatically convert into shares of common stock at a predetermined conversion rate. The conversion is automatic; the bondholder does not need to take any action for the conversion to take place. The investor now holds shares in the company instead of bonds, and the company has reduced its debt obligations.
In another example, a preferred stock agreement may include an automatic conversion clause stating that if the company undergoes an acquisition, the preferred shares will automatically convert into common stock at a specific ratio. This ensures that the preferred stockholders are automatically granted common equity in the company post-acquisition, protecting their interest without the need for further negotiations or approvals.
Example of an automatic conversion clause
Here’s how an automatic conversion clause might appear in a convertible bond agreement or preferred stock contract:
"Upon the occurrence of [trigger event], the outstanding principal amount of the Convertible Notes shall automatically convert into shares of common stock at a conversion price of [$X] per share. The conversion shall take effect without the need for any action by the holders, and the holders of the Convertible Notes will automatically receive the corresponding number of shares in accordance with the conversion formula set forth in this Agreement."
Conclusion
Automatic conversion simplifies the process of converting financial instruments into equity or other securities by setting predefined conditions under which the conversion happens automatically. This ensures that the conversion process is efficient and consistent, and it provides clear terms for both the issuer and the holders.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.