Conversion right: Overview, definition and example
What is a conversion right?
A conversion right refers to a provision in a financial instrument, such as a bond or preferred stock, that gives the holder the option to convert the instrument into another type of security, typically common stock or equity, under specified conditions. This right allows investors to convert their debt or preferred shares into equity, often at a pre-determined conversion ratio or price. Conversion rights are often included in convertible securities to make them more attractive to investors by providing the potential for upside participation in the company's growth.
For example, a holder of convertible bonds may have the right to convert their bonds into shares of the issuing company's stock at a fixed price or ratio after a certain period.
Why is a conversion right important?
A conversion right is important because it provides flexibility and potential for greater return on investment. For investors, it offers the opportunity to convert debt or preferred shares into equity if the company’s stock price rises, potentially yielding a higher return. For companies, offering convertible securities with conversion rights can attract investors by providing a lower initial interest rate or dividend, while also giving them the opportunity to reduce debt or avoid paying dividends in the future if the securities are converted into equity.
Conversion rights are also useful in protecting the investor’s value in case the company performs well, allowing them to share in the company’s growth, while still providing downside protection as a bondholder or preferred stockholder.
Understanding conversion right through an example
Imagine a company issues convertible bonds worth $10,000, which can be converted into 100 shares of its stock at a conversion price of $100 per share. If the company’s stock price increases to $150 per share, the bondholder can choose to exercise their conversion right, converting their bonds into 100 shares worth $15,000. In this case, the bondholder gains an additional $5,000 in value by converting their bond into equity, rather than keeping the bond as a fixed-income instrument.
In another example, a preferred shareholder may have the right to convert their preferred shares into common stock after a specific period, based on an agreed-upon conversion ratio. If the company’s common stock value rises significantly, the shareholder can exercise the conversion right to obtain common stock at a favorable price, potentially increasing their ownership and return on investment.
An example of a conversion right clause
Here’s how a conversion right clause might look in a contract:
“The holder of the Convertible Preferred Stock shall have the right to convert any or all of the Preferred Shares into Common Stock of the Company at a conversion rate of [insert conversion ratio], at any time after the [insert date], subject to adjustment in the event of stock splits or other corporate actions. The conversion shall be effected by the delivery of a Conversion Notice to the Company, and shall be subject to the terms and conditions outlined in this Agreement.”
Conclusion
Conversion rights offer significant flexibility to investors by allowing them to convert debt or preferred equity into common stock, often providing the potential for increased returns if the company performs well. For companies, offering conversion rights can attract investors by reducing the initial cost of raising capital and offering an opportunity for investors to share in the company’s future success. Clearly defining the terms and conditions of conversion rights in a contract ensures both parties understand how and when the rights can be exercised, providing clarity and structure in the investment agreement.
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.