Even if the company sells convertible securities in a private, unregistered transaction (or "private placement"), the company and the purchaser normally agree that the company will register the underlying common stock for the purchaser's resale prior to conversion. You can do this by researching the company in the SEC's EDGAR database and looking at the company's registration statements and other filings. The more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing.īefore you decide to invest in a company, you should find out what types of financings the company has engaged in - including convertible security deals - and make sure that you understand the effects those financings might have on the company and the value of its securities. The greater the dilution, the greater the potential that the stock price per share will fall.While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula. The company will have more shares outstanding after the conversion, revenues per share will be lower, and individual investors will own proportionally less of the company. The more shares the company issues on conversion, the greater the dilution to the company's shareholders will be.That means that the lower the stock price, the more shares the company must issue on conversion. The company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion.Here's how these deals tend to work and the risks they pose: ![]() Because a market price based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called "floorless", "toxic," "death spiral," and "ratchet" convertibles.īoth investors and companies should understand that market price based convertible security deals can affect the company and possibly lower the value of its securities. A market price based conversion formula protects the holders of the convertibles against price declines, while subjecting both the company and the holders of its common stock to certain risks. The convertible security financing arrangements might also include caps or other provisions to limit dilution (the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock).īy contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion. In a conventional convertible security financing, the conversion formula is generally fixed - meaning that the convertible security converts into common stock based on a fixed price. Companies that may be unable to tap conventional sources of funding sometimes offer convertible securities as a way to raise money more quickly. Companies that have access to conventional means of raising capital (such as public offerings and bank financings) might offer convertible securities for particular business reasons. In other cases, the company has the right to determine when the conversion occurs.Ĭompanies generally issue convertible securities to raise money. In most cases, the holder of the convertible determines whether and when to convert.
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