Convertible preference share

A preference share normally behaves like a hybrid: it pays a dividend somewhat like a bond pays interest, and ranks above equity shares if the company is wound up, but usually carries no voting rights.

A convertible preference share adds one more feature. It gives the holder the right to convert the preference shares into a set number of equity shares. The holder starts out as a fixed-income-style investor and can later become an equity shareholder, sharing fully in the company's growth.

Preference shares can be cumulative or non-cumulative: cumulative shares carry forward any unpaid dividend to be paid later, while non-cumulative shares simply lose an unpaid dividend. They can also be participating, where the holder gets a fixed dividend plus an extra dividend if pre-specified conditions are met, or non-participating, where the dividend is fixed and unrelated to the company's earnings. A convertible preference share can combine with any of these dividend structures.

Because preference shares carry features of both equity (they can be perpetual, like equity shares) and debt (a fixed dividend), the workbook calls them hybrid or blended securities. The conversion feature is what lets an investor start as a preference shareholder and end as an equity shareholder, without a fresh purchase.

An investor holds 1,000 convertible, non-participating preference shares of a company, each carrying a fixed dividend and a right to convert into equity at a ratio of 1 preference share for 1 equity share after 3 years.

For the first 3 years, the investor receives only the fixed preference dividend, ranking ahead of equity shareholders for that payout and for any liquidation proceeds. At the end of year 3, the investor converts all 1,000 preference shares into 1,000 equity shares. From that point, the investor gives up the fixed dividend and the priority ranking, and instead shares fully in whatever dividend and price appreciation the equity shares deliver — good if the company has grown, but with no fixed floor if it has not.

Chapter 7 (Introduction to Investments) introduces convertible preference shares as part of the broader discussion of preference shares and their cumulative, non-cumulative, participating and non-participating variants. Expect a question that asks how a convertible preference share differs from an ordinary, non-convertible preference share, or from a straight equity share.

• Conversion is a right, exercised by the holder, not an automatic event — a convertible preference share stays a preference share until conversion actually happens.
• Do not confuse the participating feature (extra dividend on top of the fixed one, tied to earnings) with the convertible feature (the right to become an equity shareholder) — a preference share can have either, both, or neither.
• After conversion, the holder loses the preference share's priority ranking for dividends and liquidation proceeds, in exchange for full participation in equity returns.