What is a cashless conversion?
A cashless conversion is the direct conversion of property, from one type of security to another, without any initial cash outlay by the holder. For example, the conversion of a convertible bond from debt to equity in the form of common shares.
Convertible securities contracts define all the terms of the conversion at the start of trading. Often times, the asset transfer will be triggered automatically on a specific date or when a specific event occurs, such as with the expiration of certain options or guarantees.
- A cashless conversion is when the ownership type of an asset changes without a cash outlay.
- Convertible bonds and convertible preference shares could result, if activated, in a cashless conversion to ordinary shares.
- A cashless exercise is similar in that it does not involve a cash outlay, but rather the asset is exercised through a loan or the compensation received is offset against the exercise price.
Understanding a Cashless Conversion
A classic example of a cashless conversion is when trading preferred stocks or bonds convertible to common stocks.
Employee stock options, rights, and warranties can also be cashless if the strike is zero. However, they could also be a cashless exercise. In the case of employee stock options, this is when a broker provides the holder with a loan to exercise the options at the exercise price.
After paying the fees and paying off the loan with the proceeds from the sale of some of the shares, the employee retains the remaining shares obtained from the options.
Preferred shares are a class of ownership in a corporation that has a greater claim on its assets and earnings than ordinary shares. Preferred shares generally have a dividend that must be paid before dividends to common shareholders.
Some preferred shares are convertible, which means that they can be exchanged for a certain number of ordinary shares under certain circumstances. The board of directors can vote to convert the shares, the investor can have the option to convert, or the shares can have a specific date when they are automatically converted. The conversion of preferred shares to ordinary shares is a cashless conversion.
A convertible bond is a type of debt collateral that can be converted into a predetermined amount of the underlying company’s common stock at certain times during the life of the bond, generally at the bondholder’s discretion. If triggered, the bond is exchanged for ordinary shares, making it a cashless conversion.
Unless market conditions cause automatic conversion, as defined in the contract, the procedure to convert is simply to notify the issuer of the desire to convert. The number of shares converted replaces the asset that is currently held with no money owed.
A cashless exercise is a transaction in which certain securities are exercised without making any cash payments. Such a transaction uses a broker to provide a short-term loan so that the holder exercising the options has enough money to do so.
Once the option loan is in place, the holder sells enough newly acquired shares to pay the broker the loan, fees and taxes. The person exercising the conversion then owns the remaining shares. This is a common process with employee stock options.
Warrants grant the right, but not the obligation, to buy or sell a security, most commonly a share, at a specified price before expiration. The price at which the underlying security is bought or sold is called the strike price or strike price. However, to be cashless, the order itself must be defined as a cashless order. In this case, the holder would pay the exercise price with the value of the shares received.
For example, if the guarantee is for the purchase of 10,000 shares at $ 1.00 per share, and the market price of the shares in the exercise is $ 10.00 per share, the holder, in the exercise, would receive the market value of the shares ($ 100,000) minus $ 10,000 (shares multiplied by warrant strike) for a total value of $ 90,000 or 9,000 shares.
Example of cashless conversion into convertible preference shares
Convertible preference shares have a conversion ratio, which describes how many common shares each preferred share can be converted to. For example, a $ 100 preferred stock may have a conversion rate of four. This means that the holder can convert the preferred $ 100 into four common shares.
It may be beneficial to convert if the price of the common stock is trading above $ 25 ($ 100 / conversion ratio). However, once converted, the preferred shareholder becomes a common shareholder and is no longer entitled to the preferred dividend or a higher claim on the assets. Therefore, the preferred shareholder may wish to wait until the common shares increase significantly before giving up their preferred shares.
Suppose the stock price rises to $ 40. For each $ 100 preferred share, the holder can get $ 160 in common stock (4 x $ 40). If they decide to convert the preferred shares, each preferred share will disappear from the account and will be replaced by four ordinary shares. No cash changes hands, making it a cashless conversion.