Cashless Conversion: Overview, Example, FAQ

What Is a Cashless Conversion?

A cashless conversion is the direct conversion of ownership, from one type of security to another, without any initial cash outlay by the holder. For instance, the conversion of a convertible bond from debt to equity in the form of common stock.

Contracts for convertible securities define all the terms of the conversion at the onset of the trade. Often, the transfer of assets will be triggered automatically on a specific date or when a specific event occurs, such as with the expiration of certain options or warrants.

Understanding a Cashless Conversion

A classic example of a cashless conversion is when preferred shares or convertible bonds are traded in for common stock.

Employee stock options, rights, and warrants 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 strike price.

After paying fees and paying off the loan with the proceeds from selling some of the shares, the employee retains the remaining shares garnered from the options.

Preferred Shares

Preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares generally have a dividend that must be paid out before dividends to common shareholders.

Some preferred stock is convertible, meaning it can be exchanged for a given number of common shares under certain circumstances. The board of directors might vote to convert the stock, the investor might have the option to convert, or the stock might have a specified date at which it automatically converts. The conversion from preferred to common stock is a cashless conversion.

Convertible Bonds

A convertible bond is a type of debt security that can be converted into a predetermined amount of the underlying company's common stock at certain times during the bond's life, usually at the discretion of the bondholder. If triggered, the bond is swapped for common stocks, so it is a cashless conversion.

Cashless Exercise

A cashless exercise is a transaction in which certain securities are exercised without making any cash payment. Such a transaction utilizes a broker to provide a short-term loan so that the holder exercising the options has enough money to do so.

Once the loan to exercise the options is in place, the holder then sells enough of the newly acquired shares to pay back the broker for the loan, fees, and taxes. The person exercising the conversion then possesses the remaining shares. This is a common process with employee stock options.

Warrants

Warrants give the right, but not the obligation, to buy or sell a security—most commonly a stock—at a certain price before expiration. The price at which the underlying security is bought or sold is referred to as the exercise price or strike price; however, in order to be cashless, the warrant itself must be defined as a cashless warrant. In this case, the holder would pay the exercise price from the value of the shares received.

For example, if the warrant is for the purchase of 10,000 shares at $1.00 per share, and the market price of the stock at exercise is $10.00 per share, the holder would, upon exercise, 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 a Cashless Conversion

Convertible preferred shares have a conversion ratio, which describes how many common shares each preferred share can be converted to. For example, a $100 preferred share may have a conversion ratio of four. This means the holder can convert the $100 preferred into four common shares.

It may be beneficial to convert if the price of the common stock is trading above $25 ($100 / conversion ratio). Once converted though, the preferred shareholder becomes a common shareholder and is no longer entitled to the preferred dividend or a higher claim on assets. Therefore, the preferred shareholder may wish to wait until the common stock rises significantly before giving up their preferred shares.

Assume the stock price rises to $40. For each $100 preferred share, the holder can get $160 worth of common stock (4 x $40). If they decide to convert the preferred shares, each preferred share will disappear from the account and be replaced by four shares of common stock. No cash changes hands, so it is a cashless conversion.