Conversion: Overview, definition, and example
What is conversion?
Conversion refers to the process of changing one form of asset, security, or agreement into another as specified by a contract or agreement. In a legal or financial context, conversion often applies to the transformation of convertible securities (e.g., convertible bonds or preferred stock) into equity, such as common stock. It may also refer to changes in ownership forms, contractual obligations, or other assets.
For example, an investor holding convertible bonds may elect to convert those bonds into shares of the issuing company’s common stock based on predetermined terms.
Why is conversion important?
Conversion is important because it provides flexibility and additional value to the parties involved. For investors, conversion rights can enhance the potential for returns by allowing them to participate in equity growth. For businesses, offering conversion options can attract investment and provide favorable financing terms.
Clearly defined conversion provisions ensure transparency, protect both parties, and establish fair terms for executing the conversion process.
Understanding conversion through an example
Imagine an investor purchases convertible preferred stock in a startup. The terms state that the preferred stock can be converted into common stock at a ratio of 1:10 if the startup achieves certain financial milestones. When the milestones are met, the investor chooses to convert their 1,000 shares of preferred stock into 10,000 shares of common stock, gaining a stake in the company’s equity.
In another example, a loan agreement includes a conversion clause allowing the lender to convert the loan balance into equity in the borrower’s company at a valuation agreed upon in advance. The lender exercises this option when the company reaches a funding milestone, turning debt into ownership.
An example of a conversion clause
Here’s how a conversion clause might look in a contract:
“The Holder of this Convertible Note shall have the right, at their sole discretion, to convert the principal amount of the Note, along with any accrued but unpaid interest, into shares of the Company’s common stock at a conversion price of $[Insert Amount] per share. The Holder must provide written notice to the Company at least [Insert Timeframe] prior to the intended conversion date.”
Conclusion
Conversion provisions offer flexibility and value, allowing parties to transform assets or agreements under predetermined terms. For businesses, offering conversion options can attract investors and provide alternative financing mechanisms, while investors or stakeholders benefit from the potential for increased returns or equity participation.
By including detailed and fair conversion clauses in agreements, businesses can ensure transparency, foster trust, and provide opportunities for mutually beneficial outcomes.
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.