In the last post, we discussed the major differences between the preferred and the commons stock. Preferred stock is more valuable than common stock as it grants certain rights and one of these is the conversion right.

A conversion right is the right to convert shares of preferred stock into shares of common stock. Please note that once converted, there is no option to reconvert back to preferred.

The rate or ratio at which this happens is the conversion rate or ratio. For example, a company has a conversion ratio of 2.5 for shares of preferred stock. This ratio tells us the price that the common stock needs to be trading at for the owner of the preferred stock to make money on the conversion. This price is called the conversion price, which is the purchase price of a preferred stock divided by the conversion ratio. In this case, the price would be $40. ($100/2.5)

There are two types of conversion rights: optional and mandatory. As the name suggests, the optional right is not compulsory to exercise. Optional conversion rights are typically non-negotiable. Mandatory conversion rights oblige the holder to convert her shares into shares of common stock at pre-defined events, such as an IPO. This happens automatically, that is why it is sometimes referred to as “automatic conversion”. It is very rare for a company to go public with different classes of stock (there are some cases like Google).

It is good to ensure that different investors do not have different conversion terms.