Mandatory conversion: Overview, definition, and example
What is mandatory conversion?
Mandatory conversion refers to a provision in a financial instrument or contract that requires the holder to convert their holdings into another form of asset, such as shares or securities, at a specified time or upon the occurrence of certain conditions. This conversion is automatic and compulsory, meaning the holder has no option but to comply with the terms set out in the agreement. Mandatory conversion is often seen in convertible bonds, preferred shares, or other convertible securities, where the holder must convert their instrument into common stock or other assets at a predetermined price or under specific conditions.
For example, a convertible bond may be converted into shares of the issuing company after a set period, regardless of whether the bondholder wants to convert it.
Why is mandatory conversion important?
Mandatory conversion is important because it enables the issuing company or entity to manage its capital structure, often turning debt into equity or improving its balance sheet by reducing liabilities. For the holder, mandatory conversion can result in ownership in the company (if converting into stock), potentially benefiting from future growth or dividends. It also ensures a clear timeline for conversion, which can be useful for both parties in planning their financial strategies.
For businesses, mandatory conversion can help reduce debt and strengthen equity positions, which may be beneficial in maintaining financial stability or meeting regulatory requirements. For investors, it can provide an opportunity for capital appreciation, though they may not have control over the timing of the conversion.
Understanding mandatory conversion through an example
Imagine a company issues convertible bonds that can be converted into its common shares after five years at a price of $50 per share. If, after five years, the bondholder is required to convert the bonds into shares, regardless of the company’s stock price, the bondholder must convert. If the stock price at that time is $60 per share, the bondholder benefits by receiving shares at the $50 price. However, if the stock price has fallen below $50, the bondholder may still be obligated to convert, potentially resulting in a loss in value compared to holding onto the bond.
In another example, a startup might issue preferred stock with a mandatory conversion feature, requiring that the preferred shares be converted into common stock once the company reaches a specific milestone, such as securing a certain level of funding. This ensures that the investors are converted into equity holders, diluting the ownership of the original founders.
An example of a mandatory conversion clause
Here’s how a mandatory conversion clause might appear in a contract:
“The Convertible Bonds shall automatically convert into common shares of the Company on the fifth anniversary of the issuance date, at a conversion price of $50 per share, regardless of the market price of the shares at the time of conversion. The conversion will be mandatory, and the bondholder shall have no discretion to retain the bonds after the conversion date.”
Conclusion
Mandatory conversion is a key feature in various financial instruments, where holders are required to convert their holdings into another asset, typically shares, at a predetermined time or under specific conditions. This provision benefits issuers by reducing debt and strengthening equity, while offering investors an opportunity to benefit from the company’s future growth. Understanding the terms and conditions surrounding mandatory conversion helps both parties manage expectations and plan their financial strategies effectively.
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.