Deals & Acquisitions
Feb 20, 2023
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This guide explains what preferred stock is and is designed to give you a better understanding of this type of equity investment. This guide also looks at the different classifications of preferred stock. Here are some key takeaways about preferred stock:
Preferred stock is a type of equity investment that represents an ownership stake in a business. The owners of shares of preferred stock have a right to a portion of the company’s profits.
Preferred stock is a classification of stock that has a higher liquidity position than common stock. This gives preferred stock investors a superior position in the event of a liquidation—as they are paid out before the common stock investors are. To better understand preferred stock, understand that the primary drawback to investing in common stock is that common stock has the lowest liquidity position. This directly impacts the required rate of return that common stock investors typically seek.
Preferred shareholders generally realize less of a return than common shareholders, but their investment is less risky because they are paid out before common shareholders.
Unlike common stock, preferred stock doesn’t come with voting rights, so these investors choose a higher liquidity position in lieu of the right to vote on corporate policies. Typically, common stockholders will vote (often by proxy) on company policies, potential mergers or acquisitions, and in the election of the company’s board of directors. Preferred stockholders are choosing a preferential liquidity position and a more fixed payout structure over these voting rights.
Preferred shares usually pay fixed dividends, and combined with the preferential payout to common stock, some investors consider preferred shares to be a hybrid between both bonds and common stock. They are a type of equity but have a higher liquidity position and some more debt-like payout characteristics. Some investors are particularly drawn to this type of security because of these characteristics.
This section looks at the classifications of preferred shares. Preferred shares, due to their nature can have different characteristics form one company to another. This section will look at the more common ways that preferred shares are classified.
The first, we’ll look at cumulative and non-cumulative preferred shares. Here we’re looking at what happens if the dividends are not paid by the business to the preferred shareholders as expected. With cumulative preferred shares, if the business paying the dividends, can’t payout preferred shareholders the agreed-upon (fixed) dividend, they will defer that payment to a later date and those unpaid dividends will accumulate. These dividends that accumulate will be paid out in full before any common shareholders receive a payout. Conversely, in non-cumulative preferred shares, dividends that aren’t paid out don’t accumulate. So, the business doesn’t have to pay and will likely wait until profit is sufficient to return to paying dividends to preferred shareholders. With non-cumulative preferred shares, investors are betting on the business’ ability to pay without the safety a cumulative classification would provide.
Second, we’ll look at whether the preferred shares are convertible or not. If preferred shares are convertible, they are convertible into common shares. In the instance of convertible preferred shares, there will be a pre-determined conversion ratio that will determine how many shares of common stock a preferred share is worth. If preferred shares aren’t convertible, then they cannot be converted to common shares.
Third, preferred shares can be fixed rate or adjustable rate. Usually, preferred shares offer fixed dividends. This is a feature that likens them to bonds in some ways. However, preferred shares can also have adjustable rates. So, the dividend payout on these shares is linked to the prevailing market rates (such as LIBOR) and not fixed as is normally the case.
Fourth, we’ll look at whether preferred shares are participating or non-participating. Participating preferred shares give those shareholders a right to receive their dividend payment in addition to a predetermined percentage of the common shareholders portion of a dividend payout. If the shares are non-participating, then they have no right to receive a portion of the dividends remaining for common stockholders and earn only their fixed rate dividends.
