Conversion privilege: Overview, definition, and example
What is conversion privilege?
A conversion privilege refers to the right of a holder of certain securities, such as preferred stock or convertible bonds, to convert them into a different type of security, typically common stock. This right is usually specified in the terms of the security agreement and allows the holder to exchange their current holdings for another class of securities under predefined conditions, such as a conversion ratio or during a specific period.
For example, if your business issues convertible preferred stock, the conversion privilege allows the stockholder to convert their preferred shares into common stock at a specified rate, potentially allowing them to benefit from future appreciation in the value of the common stock.
Why is conversion privilege important?
Conversion privilege is important because it offers flexibility to investors. It gives them the option to switch to a more favorable or liquid form of investment, such as converting to common stock if the company's prospects improve. For the issuing business, offering a conversion privilege can make the security more attractive to investors, as it provides the potential for future upside while offering the security of fixed returns (in the case of convertible bonds or preferred stock).
For SMBs, offering conversion privileges can help raise capital by making securities more appealing to investors. It can also provide a way for businesses to manage their capital structure and make it easier to attract investors with different risk tolerances.
Understanding conversion privilege through an example
Imagine your small business issues convertible bonds to raise funds. These bonds can be converted into shares of your company’s stock at a set ratio, such as one bond converting into 10 shares of common stock. If the company’s stock price rises significantly, the bondholder may choose to exercise their conversion privilege and convert the bonds into shares to benefit from the increase in value.
In another example, your business may issue convertible preferred stock that allows the investor to convert their preferred shares into common stock after a certain period or when specific conditions are met. If the value of common stock increases over time, the investor can convert their shares to benefit from that appreciation.
An example of conversion privilege in action
Here’s how conversion privilege might be referenced in a contract or agreement:
“The holder of the convertible preferred stock has the right to convert their shares into common stock at a conversion rate of 1:10, meaning each preferred share can be exchanged for 10 shares of common stock at any time after the one-year anniversary of issuance.”
Conclusion
Conversion privilege is a feature that allows the holder of certain securities to convert them into a different class of securities, such as common stock, under specified conditions. For SMBs, offering conversion privileges can make investments more attractive to potential investors by providing them with the possibility of future upside, especially if the company’s stock price appreciates. This flexibility can help businesses raise capital while offering investors a potentially profitable option for conversion.
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.