Conversion of securities: Overview, definition, and example
What is conversion of securities?
Conversion of securities refers to the process of exchanging one type of security, such as a bond or preferred stock, into another type, typically common stock. This right or obligation is often included in the terms of the original security and may be exercised voluntarily by the holder or triggered automatically based on specific conditions.
For example, a company might issue convertible bonds that can be exchanged for common stock at a predetermined rate, allowing bondholders to participate in the company’s equity growth.
Why is conversion of securities important?
Conversion of securities is important because it offers flexibility and potential financial benefits to both investors and issuing companies. For investors, it provides an opportunity to participate in the equity upside of the company while still benefiting from the stability of fixed-income securities. For companies, convertible securities can be a cost-effective way to raise capital, as they often come with lower interest rates or dividend requirements.
This mechanism is especially valuable in startup or growth-stage companies, where investors may prefer equity participation if the business performs well. It also helps businesses attract funding by offering investors a hybrid security that combines debt or preferred equity with the potential for future stock ownership.
Understanding conversion of securities through an example
Imagine a company issues convertible bonds to raise $1 million. The bonds include a provision allowing bondholders to convert their bonds into common stock at a rate of 50 shares per $1,000 bond. If the company’s stock price rises significantly, bondholders may choose to convert their bonds into stock to benefit from the increased value.
In another example, a startup issues preferred shares to early investors with a conversion right. If the startup later achieves significant growth and goes public, investors can convert their preferred shares into common stock, gaining the benefits of public market liquidity and potential capital appreciation.
An example of a conversion of securities clause
Here’s how a conversion of securities clause might appear in a contract:
“The Holder shall have the right, at any time and at their sole discretion, to convert the outstanding principal amount of the Convertible Note into shares of the Company’s common stock at a conversion rate of [Insert Conversion Rate], subject to the terms and conditions set forth herein.”
Conclusion
The conversion of securities provides flexibility and mutual benefits for both investors and companies, balancing stability with the potential for growth. For businesses, it’s a strategic tool to raise capital while incentivizing investor participation. For investors, it offers the opportunity to transition from fixed returns to equity gains, making it an attractive feature in financial instruments.
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.