What is an Automatic Conversion Clause?
An automatic conversion clause is a provision that allows for the automatic exchange of preferred stock or convertible debt into the underlying equity. The conversion is considered automatic or mandatory because it does not require the vote of the board of directors for the conversion to take place.
For example, an investor may own preferred stock in a startup company with an option of automatic conversion of the preferred stock to common stock upon the occurrence of a specified event. The conversion will occur based on a conversion ratio provided in the security purchase agreement.
How Does Automatic Conversion Work
When a company is raising capital, it can opt to issue either equity or debt. When the company chooses to issue equity, it allows the public to purchase shares of the company and own a stake in the company equivalent to their proportion of equity. In return, the company will pay dividends at the end of the financial period, which depends on the appreciation of the company’s share price.
An alternative to issuing equity is issuing debt to the public. An example of debt is bonds that pay periodic interest payments to the bondholders. The interest is calculated as a percentage of the principal amount, which may be agreed upon at the time of purchasing the bonds. The choice of whether to go for equity or debt depends on the cost of each option, as well as the accessibility.
A company may also decide to issue hybrid security that combines both debt and equity. A hybrid security allows investors to purchase a bond that includes an automatic conversion clause. The clause makes the security convertible to the underlying common stock at a predetermined future period. A hybrid security guarantees an investor periodic interest payments on the debt up to the conversion date, after which they will earn dividends on the common stock.
Optional vs. Automatic Conversion Rights
Conversion rights give an investor the benefit of changing their convertible debt or preferred stock to the bond issuer’s equity upon the occurrence of a specified event in the future. Conversion rights can either be optional or automatic.
1. Optional Conversion Rights
Optional conversion rights give the investors the right to convert their debt or preferred stock into shares of common stock when the expected outcomes are more advantageous to them. For example, an investor can choose to convert debt to common stock when the expected return is higher than the return attributable to the debt. The investor can exchange the bond for a predetermined number of common stock when it is more advantageous to him or her.
For example, assume that investor A holds a $1,000 bond certificate from ABC Limited, and it is convertible to 100 ABC shares. Investor A will wait until when the price per share is $10 or higher so that the shares of common stock can be valued at $1,000 or higher.
2. Mandatory Conversion Rights
Mandatory conversion rights require that debt or preferred stock should be converted to the issuer’s common stock upon the occurrence of certain events. The automatic conversion can be triggered when a company goes public through an IPO at a predetermined total value and a per share value. The IPO is referred to as a qualified IPO in the articles of incorporation. The price per share of the shares issued to the public for subscription will be a multiple (such as 3x or 5x) of the price of the preferred stock.
The conversion ratio is the number of the debt issuer’s common stocks that a stockholder will receive for each preferred stock held. The ratio is usually determined at the time of purchasing the preferred stock, and it affects the relative price of the hybrid stock. A higher conversion ratio means that stockholders will receive a higher number of common stock per preferred stock. The conversion ratio is obtained by dividing the par value of a convertible bond or preferred stock by the convertible price of the equity.
The formula is shown as follows:
For example, when investors purchase hybrid security with both debt and equity components, they will receive periodic interest payments before the conversion takes place and will be paid first in case of a liquidation. When the security is converted to equity, the investors will receive voting rights and will benefit from an increased share price.
For example, assume that XYZ Limited issued $100 convertible preferred stocks with an 8% dividend and a conversion ratio of four. The security purchase agreement provides that automatic conversion of preferred stocks to the underlying common stock will only occur when the company holds an IPO. After the company goes public through an IPO, preferred stockholders will receive four common stocks for every preferred stock held.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: