What is Convertible Preferred Equity?
A convertible preferred equity is a financial instrument that combines debt and equity. A convertible preferred equity typically gives shareholders preferred rights (such as priority dividends and liquidation preferences).
It also has the option to convert the preferred shares into common equity under certain conditions. Such hybrid structures are usually more attractive to start-ups and high-growth firms seeking capital without sacrificing immediate ownership. Businesses and investors need to understand how convertible preferred equity works.
Key features of Convertible Preferred Equity
To understand convertible preferred equity, it is important to understand key features such as liquidation preferences, dividend provisions, voting rights and conversion rights.
What is Liquidation Preference?
Liquidation preference is how payouts are made during a company’s liquidation. It is a contractual right that determines the sequence and the amount investors receive in the event the company is liquidated, sold or undergoes an exit event. Participating preferred stock allows investors first to receive their liquidation preference and then share in any remaining proceeds alongside common shareholders. By contrast, non-participating preferred stock limits investor returns to the preference amount only
Why does it matter?
The liquidation preference makes it attractive for the preferred investors in private equity, venture capital and early-stage investments where the results are uncertain. This feature protects the preferred investors from downside risk.
Example:
Suppose you acquired a startup for £15 million and have:
£7 million in convertible preferred shares (1x liquidation preference, non-participating)
£8 million in common equity
If the preferred shares are not converted, the £7 million preferred investors get paid first. The remaining £8 million goes to the common shareholders.
If the preferred shares convert to common and own, say, 50% of the company, the investors will receive £7.5 million instead. They would then choose to convert because £7.5 million> £7 million.
Key takeaways
- In downside scenarios, preferred investors are protected by Liquidation Preference.
- The liquidation preference can greatly impact the outcome of mergers and acquisitions or liquidation events.
- The liquidation preference is not standard, as it can be negotiated as part of financing agreements, especially in venture capital and private equity deals.
What are Dividend Preferences?
In simpler terms, dividend preferences specify how and when dividends are paid. Convertible preferred equity typically gives preferred shareholders the right to receive dividends before any are paid to common shareholders. However, with non-cumulative dividends, unpaid dividends do not accumulate, which can be less favourable for investors. Cumulative dividends, by contrast, provide a more predictable income stream, an appealing feature for risk-conscious investors.
Why does it matter?
The dividend preference is attractive to conservative investors with regular income needs. It also helps in offsetting the risks associated with investing in early-stage or high-growth companies. The dividend preference can also act as a form of capital-efficient financing since it is lower cost than debt but more structured than common equity.
Example:
Suppose, as an investor, you buy £2,000,000 worth of convertible preferred shares with a 5% cumulative dividend:
The company owes you £100,000 per year in dividends.
Assuming the company skips dividends for 2 years, it will owe £300,000 (£ 100,000 x 3) before any common shareholder receives a dividend.
Key takeaways
- The preferred shareholders get paid first when dividends are issued.
- Investors are protected from downside risks with cumulative dividends.
- Especially in illiquid or volatile businesses, dividend preference is preferred.
What are Voting Rights?
Voting rights are the ability for shareholders to influence a company’s decisions, which typically relates to voting on corporate matters like board elections, mergers, issuing shares or amending bylaws to the company’s charter. These rights associated with convertible preferred equity can impact corporate governance as well. With convertible preferred equity, the voting rights are usually limited or conditional, which distinguishes them from common shares, which almost always include full voting power.
Why does it matter?
It is easier for companies to raise capital without immediately diluting control by limiting voting rights. Similarly, investors may accept limited rights in exchange for preferred dividends, liquidations and other protections. The voting provisions can shift as more sophisticated investors demand greater governance influence.
Key takeaways
- The convertible preferred shareholders usually have limited or conditional voting rights.
- Some preferred shares vote on an as-converted basis, aligning them more with common shareholders.
- Voting rights are often a negotiated point in investment deals and vary depending on investor leverage and the stage of the company.
How does the conversion of Convertible Preferred Equity Work?
A defining trait of convertible preferred equity is its conversion mechanics, giving investors the option to convert their preferred shares into common shares under specific conditions. Conversion is exchanging preferred shares for common shares, allowing preferred shareholders to participate in equity upside and align themselves more closely with company’s common shareholders.
If you, as an investor, hold 60,000 preferred shares at £4 issue price, the conversion price is £1, then the conversion ratio is 4:1
If the company is acquired and each common share is worth £10:
The investor converts to 240,000 common shares
Value= 240,000 x £10 = £2.4 million
This is far more beneficial than taking a 1x liquidation preference of £240,000.
Voluntary Conversion and Automatic Conversion
Investors generally have the option to convert at their discretion; however, certain triggering events such as an initial public offering (IPO) or a merger may obligate a conversion. The common stock price may trigger automatic conversion if it exceeds a specific threshold. Here’s a detailed difference between a voluntary conversion and an automatic conversion
Anti-Dilution Protection
Anti-dilution provisions protect the investors from ownership dilution by adjusting the conversion ratio when new equity is issued at a lower price than the original preferred share price. The anti-dilution provisions can adjust the conversion price to preserve the investor’s equity stake. Common methods include:
- Full Ratchet: The conversion is based on the new, lower price.
- Weighted Average: The conversion blends the impact of old and new pricing.
Valuation Approaches for Convertible Preferred Equity
Since convertible preferred equity consists of elements of common equity and straight debt, it is quite complex to value convertible preferred equity. The valuation must reflect downside protection and upside potential including features like dividends, liquidation preference and conversion rights.
The most commonly used approaches are:
- Cost Approach: The approach values investment at its original purchase price or face value. It is mostly used in early-stage companies with little financial history. However, it does not account for changes in company value or the economic value of conversion rights.
- Discounted Cash Flow- Approach: The approach projects the company’s future cash flows and discounts them to present value using a required rate of return. It is mostly used for companies with predictable revenue or when the conversion is likely.
- Market method: The market method compares the company to similar publicly traded companies or recent private transactions.
Pros and Cons of Convertible Preferred Equity
Pros:
- Investors can receive liquidation preference and fixed dividends, which reduces risk in poor-performing scenarios.
- The conversion feature allows investors to participate in equity upside if the company performs well.
- The conversion provides funding without immediately diluting common shareholders.
- The preferred shares with structured terms can appeal to venture capitalists and private equity firms by aligning risks and returns.
Cons:
- Convertible preferred equity is difficult to understand and manage. They often have complex legal and financial terms.
- The conversion of convertible preferred equity dilutes the ownership of existing shareholders.
- Protective provisions and board rights often reduce management flexibility. It usually happens if investors gain significant influence.
FAQs
Preferred equity has special rights such as fixed dividends and priority in liquidation. These features are not available to common shareholders.
Preferred shares can be converted into common shares during IPO, acquisition or shareholder voting. It can be done either voluntarily or, in some cases, automatically as well.
Anti-dilution protection is the clauses that adjust the conversion terms. This happens when the company issues new shares at a lower price in order to protect the investor
Shreetika Kunwar
Shreetika Kunwar is a committed professional with a strong academic background in business and economics. Currently pursuing her ACCA, she brings clarity, precision and practical insight to every article she contributes.