Preferred stock is like common stock because it offers investors equity in a company. It may be less risky than common stock, however, because preferred stockholders receive profit distributions or liquidated assets in case the business fails before common stockholders. Companies of all sizes issue preferred stock, which institutions with large amounts of capital purchase.
What Is Preferred Stock?
Preferred stock represents an equity interest in a company and offers its owners regular dividend payments. Preferred stock is a widely used security because it offers a less expensive way to raise capital for high-risk companies. There are also multiple types of preferred shares, depending on payment priority and conversion options.
How Preferred Stock Works
Preferred stocks are a financial security that’s a mix of stocks and bonds. They are sometimes referred to as hybrid securities because companies issue them with a fixed face (or “par”) value, and they are entitled to a dividend equal to a percentage of par. Like any security that makes fixed payments, its value is influenced heavily by interest rates.
Multiple provisions distinguish different types of preferred stocks. These distinguish the priority of payments for different owners, the guarantees in the event of nonpayments, and any conversion options that investors can exercise. Startups seeking funding often issue convertible preferred stock, granting its owners the option to convert their shares into common stocks on a predetermined date.
Rating agencies like Moody’s rate preferred shares based on their level of risk for investors. Investors who purchase these shares receive a regular dividend payment up to a predetermined date, referred to as expiration. At the expiration date, investors can convert their preferred shares to common stock at a predetermined value. However, some preferred shares don’t have an expiration date and continue paying dividends in perpetuity or until the issuing company calls them.
Preferred Stock vs Common Stock
Common stock and preferred stock both represent an equity interest in the company. Common stock is straightforward. Each share represents a certain percentage of ownership and entitling the shareholder to dividends and voting rights. Preferred shares are more restrictive and don’t give investors voting rights. However, it offers a preference for dividends.
“Preferred stock is a bit of a hybrid between a bond and common stock in the sense that preferred shares usually have a guaranteed return amount at a fixed term. At a trigger point, the preferred stockholder has the option to sell at a predetermined rate or convent their holdings to common stock.”
―Brian Cairns, CEO, ProStrategix Consulting
For companies, preferred shares are more expensive in the long run, but have the advantage of reducing the number of voting shareholders in a company. Investors wanting voting rights prefer to hold common stock. However, if companies don’t have high enough dividends to distribute to all stockholders, they are required to prioritize preferred stockholder payments.
Investors wanting a hybrid offering that mixes the stability of debt with the upside of equity financing should consider preferred stock. Some investors that fall into this category include major insurance companies and large hedge funds wanting the long-term predictability that preferred shares offer.
Who Issues and Buys Preferred Stock
Individuals and institutional investors purchase preferred stock. The companies that issue stock are typically high-risk because of financial strain or because they are in the early stages of development. Institutional investors include banks, insurance companies, angel investors, and venture capital firms.
Common issuers of preferred stock include:
- Companies in financial distress: Companies in financial distress may issue preferred stock instead of debt or common stock. Debt and common stocks may be inaccessible in declining market conditions. During the previous financial crisis, investors like Warren Buffett bought preferred stock.
- Startups raising money from investors: Although many startups are not in immediate financial distress, investors consider these companies to be a higher risk. In these cases, venture capitalists and angel investors may want preferred stock. This gives them preference over the equity startups issue as employee stock options.
- Businesses interested in keeping control of voting: Businesses can rely on debt financing to keep voting rights in the business and avoid dilution. However, prevailing interest rates or capital distribution of the business may make preferred stock a more attractive option.
Common buyers of preferred stock include:
- Venture capital firms that invest in startups: Venture capital firms often purchase preferred shares, giving them the first rights to any dividends or proceeds from liquidation. This has the added benefit of leaving the startup without immediate debt, allowing it to stretch its cash further.
- Institutional investors with long investment horizons: Institutional investors like insurance companies and hedge funds that have long investment horizons may buy preferred stock. This type of investment grants these investors the potential upside of the company appreciating, stable payments, and tax benefits.
- Individual investors seeking dividend income: Individual investors of preferred shares are rarer because the shares are available in smaller quantities than common stock. Individuals that do buy into an offering are often interested in predictable income from dividends to grow their portfolio or supplement cash flow.
Companies that investors perceive as risky can’t cost-effectively raise money through common stocks and bonds, which leaves preferred shares as an option. In most cases, startup investors favor preferred stock because they can work directly with companies to price offerings. Matching investor demand and company needs is the most challenging part of financing offerings.
Types of Preferred Stocks
Large institutional investors like banks, insurance companies, and venture capital firms are the biggest purchasers of preferred shares. There are multiple types of preferred stock that companies issue to appeal to particular types of investors. Aside from dividend payment priority, they also offer different long-term value, upfront costs, and risk mitigation provisions.
Preferred stock types include:
- Prior preferred: The first preferred stock that a company issues. This issue receives the highest priority for dividends. The provision ensures that subsequent stock offerings don’t receive dividends before early investors.
- Preference preferred: This is the second-highest-ranking issue of preferred shares. Companies issue it after the first round of stock.
- Convertible preferred: Investors receive the option to convert preferred shares for a predetermined number of common shares on a maturity date. Investors prefer these shares if they want to participate in the potential upside of company growth. It’s also the most common offering used by startups.
- Cumulative preferred: Investors receive protection from unpaid dividends with this stock. If a company does not pay a dividend, then it accumulates, and the company must repay investors in subsequent dividend payments.
- Exchangeable preferred: Companies offer stockholders the option to exchange the stock for a different financial security. This option is uncommon and functions like a convertible preferred stock.
- Participating preferred: To mitigate stagnant dividend payouts, companies offer stockholders increasing dividends. These extra dividends trigger when the company hits certain financial goals like sales targets, earnings, or profitability.
- Perpetual preferred: Most commonly issued by corporations, it does not have a set maturity date, but the company reserves the right to redeem the stock for a different share class like common stock.
- Putable preferred: Borrowing some functionality of put options, investors can redeem these shares under specific conditions instead of a set date.
- Monthly income preferred: Companies offer some investors a combination of preferred stock and subordinated debt. Here, the company pays a monthly payment for the debt besides a quarterly dividend.
- Non-cumulative preferred: Institutional investors, like banks, purchase noncumulative preferred stock, which does not compensate investors for missed payments. This enables banks to include preferred shares as part of Tier-1 capital required by the Basel Capital Accord.
“Some preferred stocks are convertible. This means that they may be exchanged at a predetermined rate for the common stock of the same corporation at the discretion of the preferred shareholder. This will be advantageous when the price of the common shares is increasing due to the fixed rate of exchange. Therefore, the preferred stock investor will be able to participate in the equity growth in a manner similar to common stockholders while retaining the relative security afforded the preferred shareholders.”
―Robert R. Johnson, Ph.D., CFA, CAIA, Professor of Finance, Creighton University
Institutional vs Individual Preferred Stockholders
Individual and institutional stockholders differ based on their negotiating leverage and the tax treatment of their investments. Institutional investors are major buyers when a company issues stock and may have more leverage to negotiate beneficial terms. Institutional preferred stockholders receive additional benefits in the form of lower income tax rates on preferred stock.
“Tax laws only require a company to pay income tax on 30% of the dividends from preferred stock. This 70% tax exemption is not available to individual investors who hold preferred stock.”
―Jared Weitz, CEO, United Capital Source Inc
Individual investors receive preferred tax treatment for dividends compared to bonds, but the overall benefit is smaller compared to institutional investors. This is because the IRS taxes dividends differently than interest earnings, with a resulting lower tax rate for dividends for everyone but borrowers in the highest tax bracket.
Advantages & Disadvantages of Preferred Stocks
There are multiple advantages and disadvantages of preferred stock that both investors and companies raising capital should consider. Startups can lower the cost of fundraising but increase future equity dilution with preferred shares. Investors receive predictable income and dividends but lack voting rights and the full upside benefits of common stockholders.
Advantages of Preferred Stocks
Advantages of preferred stock include:
- Preference for dividend distribution: Investors receive preference during the distribution of dividends, which is where preferred stock gets its name. This can make companies that are underperforming a lower risk investment and results in more predictable earnings for investors.
- Lower costs for startup fundraising: Fundraising for startups is already difficult, and startups avoid debt because it deteriorates their cash position. Convertible preferred shares fill that gap by balancing the accessibility and risk of debt vs equity financing.
- Predictability as a source of income: Investors that are relying on dividends to supplement income often turn to preferred stock. The predictability of a set dividend and the preference over common stockholders for distribution make these shares a more stable source of income.
Disadvantages of Preferred Stocks
Disadvantages of preferred stock include:
- Lack of voting rights: Preferred stockholders rarely have voting rights, except for institutional investors that can take part in major decisions. This means that preferred stockholders have limited influence over the company’s direction, similar to bondholders.
- Exposure to interest rate risk: Preferred stocks experience fewer variations in price because of a company’s earnings or major announcements. However, the value of preferred shares varies with current interest rates because investors price them similar to debt instruments.
- Limited upside potential: While many preferred shares are convertible to common stock, they have limited upside potential. While the company may perform well, investors still receive only the agreed-upon dividend.
Common Preferred Stock Misconceptions
Investment information is littered with misconceptions, and it’s important that readers confirm expectations with reputable sources. Preferred stock is not safer, guaranteed, or always exchangeable for common stock. Startups and at-risk companies are not the only originators, and institutional investors are not the only buyers.
Common preferred stock misconceptions include:
- It is safer than common stock: Every investment has risks, and while the dividend payments are safer with these stocks, there are other risks. For example, they are more impacted by interest rate changes than common stocks.
- Income is guaranteed: In many circumstances, the dividend payments from a preferred stock is guaranteed. However, sometimes, lenders may have provisions that allow them to postpone, reduce, or eliminate dividend payments to stockholders.
- It can be exchanged for common stock: Although most preferred shares have a maturity date and a set conversion to common stocks, this isn’t always the case. Sometimes, companies may keep the right to set the exchange value, and some companies offer preferred shares in perpetuity.
- Startups should always use it: It’s common for entrepreneurs to use preferred stock to raise capital from angel investors and venture capitalists. However, the cost of equity financing is important to consider, and startups should evaluate if they have leverage in a funding deal.
- Only at-risk companies offer it: While at-risk companies offer convertible shares, companies that are performing well may also do so. There are multiple reasons a company might do this, but rating agencies take these reasons into account when grading an offering.
- It is only available to institutional investors: Institutional investors dominate preferred share trading, but they are available to individual investors. Investors should consult an investment advisor to determine if it fits their risk profile, investment goals, and overall portfolio.
“Entrepreneurs should understand that investors have their own goals and the funding environment is always evolving. It’s important to have an advisor that can provide guidance on recent deal structures and industry trends around startup fundraising. It’s also important to understand if a startup has any leverage in the negotiations.
“If the company and the founding team can get multiple investment offers, then they may be able to negotiate better terms. However, entrepreneurs outside these circles, have little leverage and will have few tools to negotiate with.”
Preferred Stock Frequently Asked Questions (FAQs)
Investors, business owners, and readers will have questions that we did not answer in this article because it only scratches the surface of preferred stocks. We gathered some common questions asked on our site and around the web and invite readers to ask any additional questions in the Fit Small Business forum.
Why would you buy preferred stock?
Investors buy preferred stock because they want an asset that represents the upside of equity with the benefits of debt. Preferred stock offers investors an opportunity to earn money if a company appreciates in value, while also guaranteeing them a regular income through dividends.
How do you get preferred stock?
Individual investors purchase preferred stock on the open market. Investors won’t find preferred shares in an investment app on their phones but can purchase the shares through a broker. There are many factors to evaluate before investing in preferred shares, and it’s best to consult an investment professional.
Is preferred stock a good investment?
Preferred stock can be a good investment for investors seeking a predictable source of income from dividends. Companies pay preferred share dividends before distributing money to common stockholders, making dividend payments more likely for this class of shareholders. Preferred shares can also have higher yields than corporate bonds with a higher associated risk.
What is the downside of preferred stock?
There are several disadvantages to preferred stocks for investors. These include limited upside potential, sensitivity to interest rates, and lack of voting rights. Also, preferred stockholders are paid before common stockholders, but payment is not guaranteed if a company cancels dividends, adding some dividend growth and income risk.
How often does preferred stock pay dividends?
Companies pay preferred stock dividends on a monthly or quarterly basis. Although some preferred shares pay investors annually, this is a rare arrangement and typically reserved for institutional shareholders. Preferred stockholders have priority for payments over common stockholders.
Companies in the early stages of development or at risk because of financial difficulty issue preferred stock to raise money. Preferred shares are like debt because they offer dividends and are usually sold at a set price, and similar to common stock because they represent equity in the company. However, preferred stockholders don’t have voting rights and only share in company upside if they are convertible.