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Definition: Convertible Preferred Stock
A convertible preferred Stock is a preferred stock which can be converted into common stock at a specified date and a conversion ratio which has been pre-determined when the Convertible preferred stock was issued. A company issues preferred stocks (which have greater preferences from common stocks) when it urgently needs money.
There are a number of options for a company to raise money when needed. They are short-term or long-term loans, common stocks, preferred stocks which may or may not be convertible. A convertible security is one which can be converted into another type of security. A non-convertible stock offer higher returns than convertible stock to an investor while a convertible stock offers an option to convert it into common stock that essentially means being a partial owner in the company. The difference between the common stock and preferred stock is in the payment made to both types of stock owners at times of bankruptcy. The preferred stock owners are paid prior to common stock owners at the time of liquidation of a company. In convertible preferred stock, the owner has to option whether he wants to convert the stock into a common stock or not. The purpose of issuing a convertible preferred stock lies in the fact that sometimes for a company with lower credit rating, it’s hard to raise capital. So providing the possibility of a fixed dividend and an option to convert the security into common stock after a period of time, the company can raise money through this type of instrument. There is a pre-decide period of time for conversion and there is a conversion ratio. The conversion ratio refers to the divisible ratio in which the convertible preferred stocks would be broken after the conversion. That means if an investor has 100 convertible preferred stocks of a company and a conversion ratio of 3, then after the conversion the investor will have 300 common stocks of the company.
For Example: If you have 1000 convertible preferred shares of a company ABC on 1st April 2004. The company has issued the shares with option to convert those shares into common shares on 1st of April 2007 with conversion ratio of 3. Hence you can convert the shares into common shares at this date and have 3000 common shares. Normally you would look at the share price of the company and see if it would be profitable for you to have common shares of the company or it would be a loss and you would have to option to convert or not to convert the stock.
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