What is Convertible Preferred Stock?

Convertible preferred stock is a type of stock that the owner has the option to convert into the common stock of the issuer. The number of shares received as a result of this conversion is stated in the preferred stock agreement. The conversion feature is a useful one for investors, since it allows them to receive a preferred stock dividend and also participate in any upward change in the price of the issuer’s common stock. Thus, an investor has the security of a regular return and a chance at a higher return.

Convertible preferred stock is an especially useful tool for a small startup business, because the conversion feature attracts investors who might otherwise not be interested in making an investment in the business.

Example of Convertible Preferred Stock

An example of convertible preferred stock is Berkshire Hathaway’s investment in Bank of America in 2011. During the aftermath of the 2008 financial crisis, Bank of America (BoA) was struggling and needed to strengthen investor confidence. In 2011, Berkshire Hathaway invested $5 billion in BoA’s preferred stock with a 6% annual dividend. The deal also included warrants allowing Berkshire to purchase 700 million shares of BoA common stock at a fixed price of $7.14 per share. In 2017, Berkshire exercised the option to convert the preferred shares into common stock, making a massive profit as BoA’s stock price had significantly increased. This is a classic example of how investors use convertible preferred stock to gain steady income (through dividends) while securing the option to convert into common stock for capital appreciation.

Impact of Convertible Preferred Stock on Earnings per Share

If a publicly-held business has issued convertible preferred stock, it is considered to be anti-dilutive when the dividend on any converted shares is greater than basic earnings per share. This issue does not arise for privately-held businesses, which are not required to disclose any earnings per share information.