Going public is one option a business has to raise cash. The company may achieve that goal through debt or equity.
Because there’s no requirement to repay cash raised through a stock offering, it is a more attractive option for some companies than debt. But if a company can’t meet the minimum listing dollar amount set by an exchange, the company may instead choose to restructure existing convertible debt by exchanging it for equity, thereby eliminating some debt.
Raising Capital by Equity
A company that’s considering raising capital by converting bonds to stock should be aware that, by doing so, the company relinquishes ownership and voting rights when it issues equity. Stockholder wealth, however, may be increased by both share price appreciation in times of revenue growth and, possibly, dividends. In contrast, the interest debt holders receive remains static regardless of company performance.
What Is a Convertible Security?
Convertible bonds and preferred stocks are examples of securities that are convertible into common stock. Whereas the convertible bond is a debt hybrid product, the convertible stock is a hybrid equity product.
A company can convert the security to a different type of security that’s issued by the same organization as that which issued the convertible security. Typically, convertible securities are converted to shares of common stock.
What Is the Conversion Ratio?
To convert a security to stock, a company sets both the date the shares will be issued and the ratio at which the investment, such as a convertible bond, is converted to another security, such as common stock. The number of common shares an investor receives in exchange for a convertible security is referred to as the conversion ratio. The greater the number of common shares an investor receives in exchange for each convertible security, such as a convertible bond, the higher the conversion ratio.
Read More: The Disadvantages of Convertible Debentures
Significance of the Conversion Ratio
A company’s leadership sets the security’s conversion ratio at the date and time of issue. That ratio impacts the market price of a security. The higher the conversion ratio, the greater the number of common shares a stockholder will receive for each convertible that’s exchanged for stock.
Consequently, the conversion ratio dictates the conversion premium, affects the convertible security’s market price and thereby the benefit to the investor of converting one investment to another. For instance, assuming a low conversion premium, it’s likely a convertible bond’s market price will decrease if the related common stock price falls. If no financial benefit arises from the conversion, or if the process doesn’t ensure you break even, there’s no reason to do so.
Elements of the Conversion Ratio
To calculate a conversion ratio, you divide a convertible security’s par value by the equity’s conversion price.
A security’s par value is the security’s face value. For instance, if a bond’s face value is $500, its par value is $500. The security’s par value is the investment’s value at maturity.
In turn, the conversion price of the debt or equity equals the price per share of common stock to which the security is converted. An organization’s management sets the equity’s conversion price before it issues the convertibles to investors.
Typically, the conversion price is significantly higher than the price of the issuing organization’s common stock. This strategy is a means to maintain or increase the market value of the common shares to which the convertible investment vehicle is converted.
3 Steps to Calculate the Conversion Ratio
To calculate a conversion ratio, proceed as follows:
- Identify the par value of the debt or equity.
The par value is the face value of a stock or bond.
- Determine the conversion price.
The conversion price is the price that management sets for each share of common stock. The price, which is set by management when the convertible debt or equity is issued, will be stated in a stock’s prospectus.
- Calculate the conversion ratio.
The conversion ratio, or the number of shares that the holder of the convertible debt or equity will receive, equals the convertible security’s par value divided by the conversion price of the equity.
The conversion ratio is calculated at the time the convertible security is issued, so the ratio has a positive or negative effect on the market price of the security.
Examples of the Conversion Ratio
The conversion ratio applies to the convertible bond and the convertible preferred share.
The Convertible Bond
The convertible bond is a hybrid security, which includes the option for the bond’s holder to convert it to equity. The investor’s registration statement indicates the number of shares that will be granted when the bond is converted.
Assume a convertible bond with a par value of $1,000 can be converted to 20 shares of common stock. In this case, the bond’s conversion ratio is 20-to-one.
You can calculate the conversion ratio by dividing the bond’s par value by the share price. If the conversion price for each common stock share is $10, the conversion ratio is calculated by dividing $1,000 by $10 to determine an investor will receive 100 shares of the issuer’s common stock at conversion.
The Convertible Preferred Share
Assume an investor purchases 1,000 shares of convertible preferred stock on January 1. Each preferred share pays a 5 percent dividend, and the preferred shares can be converted to common shares on February 1. The conversion ratio is five, meaning the investor receives five common shares for a preferred share.
On the conversion date, the preferred stock’s market price is $50, and common stock trades for $20 per share. In this scenario, $50 divided by five equals $10. This means the conversion will result in a gain of $20 minus $10, or $10 per common share. The break-even point is $50 divided by 5, or $10 per share.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.