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pref to common shares conversion basics


How the Conversion Ratio Works
The conversion ratio represents the number of common shares that shareholders may receive for every convertible preferred share. The conversion ratio is set by management prior to issue, typically with guidance from an investment bank. For Acme, let's say the conversion ratio is 6.5, which allows investors to trade in the preferred shares for 6.5 shares of Acme stock.

The conversion ratio shows what price the common stock needs to be trading at in order for the shareholder of the preferred shares to make money on the conversion. This price, known as the conversion price, is equal to the purchase price of the preferred share, divided by the conversion ratio. So for Acme, the market conversion price is $15.38 or ($100/6.5).

In other words, Acme common shares need to be trading above $15.38 for investors to gain from a conversion. If the shares do convert and drop below $15.38, the investors will suffer a capital loss on their $100-per-share investment. If common shares finish at $10, for instance, then convertible preferred shareholders receive only $65 ($10 x 6.5) worth of common share in exchange for their $100 preferred shares. (The $100 represents the parity value of the preferred shares.)