One of the most common forms of investment for private equity - especially venture capital - in new business ventures is convertible preferred stock. Convertible preferred stock makes sense for high-risk investments for a number of reasons.

Convertible preferred is a hybrid of debt and equity. It is senior to equity, which means that in the event of business failure, preferred shareholders receive all their investment back from liquidation proceeds before common shareholders receive payment. It is junior to debt, which means that in the event of business failure, debt holders must be paid off before preferred shareholders receive any payment. Like debt, preferred stock pays a fixed cash flow, called dividends, usually on a quarterly or annual basis.

The problem with straight common stock is that most of the time the entrepreneur retains controlling interest and the investor has only limited control of the investment. Preferred stock allows the investor to impose specific restrictions and covenants over entrepreneurial behavior. This is critical since many new ventures fail, and in the process of failing the entrepreneur may take desperate measures to try to preserve the enterprise. In the event of bankruptcy, the seniority of preferred over common allows investors to step in and protect the remaining assets.

The convertibility clause provides upside potential. It allows the investor to convert, or send in their preferred shares and receive common shares.

Investors typically will not convert without a reason. Preferred shareholders have all the upside potential of the common. Since they can convert at will, the preferred shares must sell for at least the value of the common shares that the preferred can convert into. Usually, the preferred shares sell for more than the value of the underlying shares.

There are two reasons why the convertible preferred is worth more than the underlying shares into which they can be converted. First, preferred shares pay dividends while common stock usually doesn't. As a result, the preferred investor receives all the upside potential of the common stock and more cash while he or she waits.

Second, if something goes wrong, the preferred shares are more protected. Since the preferred shares are senior to common, the preferred shareholders receive all their investment back before the common shareholders are paid anything.

Companies that are paying taxes and can take advantage of interest tax deductions may choose to issue convertible debt rather than convertible preferred stock since preferred dividends are not tax deductible. However, most new ventures are not profitable at first and choose convertible preferred stock since it is less likely to cause bankruptcy. If the company misses a payment on debt, it is technically in default, whereas most preferred stock has a cumulative provision that allows a dividend to be missed without causing default; the company can pay accumulated dividends later.