Convertible securities: Overview, definition, and example
What are convertible securities?
Convertible securities are financial instruments, such as bonds or preferred stock, that can be converted into a company’s common stock at a later date, under specific conditions. These securities give investors the option to convert their holdings into a predetermined number of shares of the company’s common stock, typically at a set conversion price. Convertible securities are often issued by companies as a way to raise capital while offering the potential for upside if the company’s stock price increases. They provide investors with the benefits of both fixed income (such as interest or dividends) and the opportunity for capital appreciation.
Why are convertible securities important?
Convertible securities are important because they offer flexibility and potential for both the issuer and the investor. For investors, these securities combine the security of bonds or preferred stock with the possibility of benefiting from the growth of the company through stock conversion. This can be particularly attractive if the company’s stock price is expected to rise in the future. For companies, issuing convertible securities can help raise capital at a lower cost, as the securities may offer lower interest rates or dividends compared to regular bonds or preferred stock. Additionally, convertible securities can provide an alternative to issuing common stock, which might dilute existing shareholders.
Understanding convertible securities through an example
Let’s say a company issues convertible bonds with a face value of $1,000 and a conversion price of $50 per share. If the company’s stock price rises above $50, the bondholder can choose to convert the bond into 20 shares of the company’s stock ($1,000 ÷ $50 per share). If the stock price rises significantly, the bondholder can profit from the appreciation of the stock, while still receiving interest payments until the bond is converted.
In another example, a company may issue convertible preferred stock. A holder of the preferred stock could convert it into common stock at a predetermined conversion ratio. If the company’s common stock price rises, the holder may choose to convert the preferred stock into common shares to benefit from the price increase, while also receiving any dividend payments associated with the preferred stock.
An example of a convertible securities clause
Here’s how a clause related to convertible securities might appear in an agreement:
“The Convertible Bonds may be converted into common stock of the Company at the option of the holder at any time prior to the maturity date, at a conversion price of $50 per share. Upon conversion, the holder will receive common stock in exchange for the bond’s principal value.”
Conclusion
Convertible securities provide a hybrid investment opportunity that offers both fixed income and the potential for equity participation. They allow investors to benefit from the upside potential of the company’s stock while maintaining the security of bonds or preferred stock. For companies, convertible securities can be an attractive way to raise capital with relatively lower borrowing costs and without immediately diluting ownership through the issuance of common stock. These securities are a valuable tool for both companies and investors looking to balance risk and reward.
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.