Playing with shares is always a risky business; still, you should do that to grab some good returns. Convertible preferred shares are a good instrument as it gives you a predetermined return and the option for value appreciation.
Concept
This type of shares comes with the option that the shareholder can convert them into a fixed amount of common shares after a pre-decided time span. Both debt and equity features are present in these shares. You earn interest on the debt amount and when it is converted, the equity aspect comes into play.
These shares generate fixed amount income and at the time of conversion, if the price of the shares rises, there is the possibility of capital appreciation. This conversion is normally subject to the shareholder’s wish but in exceptional cases, the issuer can force conversion.
Gain to Venture Capitalists
The best aspect of these shares is that you benefit from the growth of the issuer company but secure yourself for its bad performance. This is the main instrument of angel investors and venture capitalists to earn ownership share in a company. Convertible preferred shares are the best to invest in start-ups. However, it is vital to be clear on the terms and conditions of conversion to save yourself from huge losses.
Conversion Decision
Say, you bought 100 convertible preferred shares of ABC Company by paying INR 500 for each. This means you have invested (100 x INR 500) = INR 50,000 in total. Each of the shares can be converted after five years period into 50 common shares (known as conversation ratio) and during these years, they earn an annual interest of 5%. This means each share earn you INR 25 per year.
After five years, if you wish to convert them into common shares, each will cost you (INR 500/ 50) = INR 10 (known as conversation price). Then, what should be your optimal strategy? If the market price of the common share is greater than INR 10, you should convert and vice versa.
Say, the market price is INR 15 and by converting you gain (INR 15- INR 10) = INR 5 per share. From each convertible share, you gain (INR 5 x 50) = INR 250 and from 100 such shares, you gain total (INR 250 x 100) = INR 25,000.
On the other hand, if the market price is, say, INR 5 per common share, it won’t be worth converting. You lose (INR10 – INR 5) = INR 5 per common share which means (INR 5 x 50 x 100) = INR 25,000 for all the convertible shares. Even then, you need not worry. Keep on enjoying the interest income and wait for good time to come.
The Bottom Line
Companies which need additional funds but not additional voting partners issue preferred shares. To make things a bit soft, they can include the conversion option. If the company is not performing well currently, these are nothing but a short-term bond investment. Choosing the right company is thus the trickiest part of the whole story.
