Preference shares are considered to be the best form of equity security, because of the liquidation and dividend preference rights which are 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 looks at why anyone with a preference share would want to convert it to ordinary shares with lesser rights.

When are Convertible Preference Shares Convertible?

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. 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?

IPOs

Regarding an IPO, preference shares often automatically convert into ordinary shares provided certain pre-agreed criteria is 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 converting on an IPO on a minor stock market raising little money.

Share or Business Acquisitions

A shareholder with preference shares may have the option to convert his or her shares into ordinary shares in regards to 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, let’s take a look at two scenarios and the following facts:

  • Original investment by the shareholder with preference shares: $1 million
  • Number of preference shares issued to shareholder: 10,000 (50%)
  • Number of ordinary shares on issue: 10,000 (50%)
  • Post-money valuation: $2 million
  • Liquidity Preference: 1x purchase price (this means the shareholder will get up to 1x its investment back on a liquidity event, assuming there are sufficient funds)
  1. In the first scenario, let’s say the acquisition price is $500,000. If the shareholder does not convert their shares into ordinary shares, they would be entitled to $500,000 (via their liquidation preference), and if they did convert 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.
  2. In the second scenario, let’s say the acquisition price is $4 million. If the preference shareholder does not convert their preference shares into ordinary shares, they will get $1 million (via their liquidation preference), and if they do 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.

Despite the obvious advantages of owning preference shares, it can sometimes be beneficial to convert those preference shares into ordinary shares on a liquidation event. Before exercising any rights you may have to convert your shares, it is important to consider the circumstances of the particular situation. If you require any assistance with corporate matters, please do not hesitate to contact one of our specialist corporate lawyers.

Jill McKnight

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