A company can issue different classes of shares, and the rights and restrictions attached to shares in a class distinguish it from other classes. Preference shares are considered the best form of equity security because of the liquidation and dividend preference rights usually attached to them. Hence, many people wonder what the purpose of a convertible preference share is. Convertible preference shares are preference shares that can be converted into ordinary shares. This article examines why anyone with a preference share would want to convert it to ordinary shares with lesser rights.
What Are the Different Types of Preference Shares?
Firstly, there are several different types of preference shares to consider. These include:
- convertible shares;
- converting shares;
- cumulative shares; and
- redeemable shares.
The below table goes into each type of preference share in further detail.
| Type | Description |
| Convertible Preference Share | Convertible preference shares start by paying fixed dividends at regular intervals. Then, they convert to ordinary shares or become redeemable for cash at a specified rate and time. |
| Converting Preference Share | Unlike convertible preference shares, these shares must convert to ordinary shares and usually do so at a fixed-dollar amount. |
| Cumulative Preference Share | If a company cannot pay the dividends they owe to shareholders, the dividends simply accrue, and the company will pay them when they are financially stable. Ordinary shareholders will only receive payment after the cumulative preference shareholders have received their dividends. |
| Redeemable Preference Share | Shareholders with redeemable preference shares may redeem these for cash at the company’s discretion. |
It is important to note that all preference shares come with a liquidation preference in the company constitution. A liquidation preference specifies when and how much you will pay back investors in the event of an exit. However, the amount of liquidation preference can differ. As a holder of preference shares, the higher the liquidation, the better. Currently, a 1x purchase price liquidation preference is standard in the Australian market.
When Do Convertible Preference Shares Convert?
Usually, convertible preference shares convert upon a liquidity event. A liquidity event is generally a share or business acquisition or an initial public offering (IPO). Preference shares usually convert into ordinary shares automatically on an IPO.
Continue reading this article below the formLiquidity Events
A shareholder with preference shares may have the option to convert preference shares into ordinary shares on a share or business acquisition. But in what circumstances would they do this?
Initial Public Offerings
Regarding an IPO, preference shares often automatically convert into ordinary shares, provided specific pre-agreed criteria are met. Pre-agreed criteria may include:
- the amount raised by the IPO; and
- the price per share to ensure the IPO is legitimate and to prevent shares from converting on an IPO on a minor stock market from raising little money.
Share or Business Acquisitions
A shareholder with preference shares may be able to convert their shares into ordinary shares regarding share or business acquisitions. In what circumstances would they choose to convert their shares into ordinary shares with lesser rights?
To better answer the question, consider the following two scenarios with these facts. A company has:
- an original investment by the shareholder with preference shares at $1 million;
- issued 10,000 preference shares issued to the shareholder (50%);
- 10,000 ordinary shares on issue (50%);
- a $2 million post-money valuation; and
- liquidity preference of 1x purchase price (this means the shareholder will get up to 1x its investment back on a liquidity event, assuming there are sufficient funds).
| Scenario 1 – acquisition price of $500,000 | If the shareholder does not convert their shares into ordinary shares, they would be entitled to $500,000 (via their liquidation preference). Alternatively, if they converted their preference shares into ordinary shares, they would receive $250,000 (50% of the acquisition price). In this scenario, it is better not to convert their preference shares into ordinary shares. |
| Scenario 2 – acquisition price of $4,000,000 | Suppose the preference shareholder does not convert their preference shares into ordinary shares. In that case, they will get $1 million (via their liquidation preference). If they convert their preference shares into ordinary shares, they will get $2 million (50% of the acquisition price). In this scenario, it is, of course, better to convert their preference shares into ordinary shares. |
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Key Takeaways
Convertible preference shares are preference shares that can be converted into ordinary shares. Additionally, preference shares come with a liquidation preference. If the company becomes insolvent, the preference shareholders will be paid out before the ordinary shareholders. Ultimately, convertible preference shares typically convert upon a liquidity event.
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Frequently Asked Questions
Convertible preference shares start by paying fixed dividends at regular intervals. Then, they convert to ordinary shares or become redeemable for cash at a specified rate and time.
Unlike convertible preference shares, converting preference shares must convert to ordinary shares and usually do so at a fixed-dollar amount.
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