Preferred Stock

This article will explain the corporate security of preferred stock. The overview provides an introduction to the basic characteristics of preferred stock. These characteristics include the most common types of preferred stock, typical classifications of preferred stock and the rights of preferred stockholders. In addition, factors that a corporation's board of directors typically consider in determining whether to issue preferred stock are explained, including creating equity, minimizing corporate financial obligations and controlling a corporation's governance. In addition, issues that can affect the value of preferred stock, such as stock splits, stock repurchase programs and risk are explained to help illustrate the role that preferred stock can play in the growth and profitability of a company.

Keywords Common Stock; Debt; Dividend; Equity; Liquidation; Preferred Stock; Priority; Risk

Finance > Preferred Stock

Overview

Stocks are among the most popular investment options for modern investors. Stocks are shares of a company that provide investors with partial ownership in a company. Thus, owning a stock is tantamount to being part owner of a company. Corporate ownership provides stockholders with many benefits. Shareholders gain the right to influence how a company is run through their voting power, and they have a right to benefit from company’s profits if and when they are distributed in the form of dividends, as well as a claim on the company’s assets in the event of liquidation. The more shares of a company an investor owns, the more influence the investor has regarding the way the company is run and thethe greater the investor’s claim on the company’s earnings and assets. Thus, there are many reasons why investors purchase shares of stock, including shares of preferred stock.

There are also many reasons why companies issue stock. When a company issues stock, it is generally trying to generate corporate finances to subsidize specific growth objectives. Companies may choose from several types of stock to issue shares of stock that will best serve the corporation's needs. The two most common types of stock that corporation's issue are common stock and preferred stock. Common stock provides shareholders partial ownership in a company as well as certain rights. For instance, common shareholders are entitled to the right to vote on the board of directors and other important corporate matters such as stock splits or a merger. Common stock, however, has limited priority. This means that common shareholders only have access to a company's assets after a company's creditors and preferred shareholders have been paid. For instance, when a company is profitable, common stock shareholders receive dividend payments only after the distribution of dividends to all preferred shareholders. And in the event of a corporate liquidation, common stock shareholders receive only those assets left after all creditors, bondholders and preferred shareholders have received their full payment.

Preferred stock is generally considered a less risky investment in that it combines the ownership element of common stock with a more senior priority status for debt repayment. While an investment in preferred stock does not provide shareholders with a promise that they will receive a fixed rate of return on their shares or that their investment is protected and will be repaid in full (as bondholders and creditors enjoy), preferred shareholders have priority over common-stock shareholders, and thus are paid dividend distributions before any common-stock shareholders are paid. Venture capitalists invest primarily in preferred stock, and the U.S. Treasury, through the Troubled Assests Relief Program, acquired vast amounts of preferred stock as a mechanism for preserving corporate giants.

Thus, there are several differences between common stock and preferred stock. As a result, when a company issues both common stock and preferred stock, it creates two classes of owners with each group having different rights and privileges. In sum, with preferred shares, investors are usually guaranteed a fixed dividend while common-stock shareholders receive variable dividends that are never guaranteed. Also, in the event of liquidation, preferred shareholders are paid before the common shareholders but after debt holders. Thus, preferred shareholders trade a more secure investment for fewer voting rights than common shareholders possess.

The following sections provide a more in-depth explanation of these concepts.

Basic Financial Concepts

Types of Preferred Stock

There are a number of different types of preferred stock. Corporations may issue these types of stock by themselves, or these characteristics may be combined to create more specialized forms of corporate securities. The following categories represent the most commonly issued forms of preferred stock.

• Cumulative: These shares give their owners the right to "accumulate" any dividend distributions that were due but not paid because of a corporation's financial shortfalls. If a company's earnings and profits begin to increase and the company decides to resume paying dividends, cumulative shareholders receive their missed payments in addition to their current dividend distribution before any common-stock dividends are distributed. For example, if Corporation A has 5,000 shares of $5 cumulative preferred stock outstanding but the board of directors did not declare a dividend in 2005 or 2006, these shares will have to be repaid in full in any future distributions before any common-stock dividends may be declared. Thus, if in 2007 the board of directors declares a dividend, cumulative preferred shareholders must be paid $75,000 (,000 shares x $5 x 3 years) before any payment can be made to any common-stock shares.
• Non-Cumulative: Holders of non-cumulative preferred stock lose their dividend for any period in which the directors do not declare a distribution. In other words, dividend payments do not accumulate. However, non-cumulative preferred shares retain a preference that generally entitles them to a fixed amount of money before distributions can be paid to common-stock shares. However, this right is not absolute. A corporation's board of directors must first declare a dividend before the preferred non-cumulative shareholder has any right to receive a payment.
• Participating: Generally, preferred shares are entitled only to their stated preference, or the payment rights that are assigned to that type of share. However, preferred shares may be designated as “participating,” in which case they have a right to participate in whatever the common-stock shares receive while still receiving their own preference. Thus, if, during a given year, common stock dividends are greater than those of preferred stock dividends, participating preferred shares entitle their shareholders to “participate” in these dividend increases so that the shareholders receive the share’s own preference along with the higher dividend payments of common-stock shares.
• Convertible: These shares may be converted into shares of common stock at a set rate at the shareholder's option. The value of convertible shares tends to track the price of the common stock. When convertible stock is delivered in exchange for common stock, the parity price is the price at which the shares of common stock are equal in value to shares of preferred stock. Thus, if a preferred convertible stock is converted into two shares of common stock, the parity price of the common stock is one half the price of the preferred convertible stock. Convertible shares typically receive a conversion price when they are issued to allow for a simple conversion to a company’s common stock at the given rate.
• Callable: These are shares that the corporation reserves the right to "call," i.e., to buy back at some price that is generally premium to the issued price. Thus, these shares must be sold back to the issuer at its request.

These features of preferred shares can be combined to create different forms of corporate preferred stock. For example, a corporation could issue a non-cumulative, participating preferred stock or a convertible, cumulative, participating preferred stock. A corporation's board of directors typically weighs the financial needs of the company against the characteristics and benefits of each form of preferred stock to determine which types of shares to issue.

Classes of Preferred Stock

In addition to various types of preferred stock, there are also different classes of preferred stock. The classes of preferred stock differ according to the precedence given to each class regarding the distribution of dividends and company assets at liquidation. When a company issues several classes of preferred shares, the classes are generally distinguished by being labeled as Class A or Class B preferred, with the Class A shares having precedence over shares of Class B for dividends and priority at liquidation. A company may issue classes of stock to indicate ownership in a specific division or subsidiary of the company or to indicate shares that sell at different market prices or that have differing dividend policies, voting rights or transfer restrictions.

Rights of Preferred Stockholders

Like common stockholders, preferred stockholders have several rights as shareholders. First, preferred stockholders have the right of preference in dividend distributions. While a company does not have to pay dividends, if dividends are paid, preferred stockholders must receive full payment before any common stockholders receive dividends. In addition, if the preferred stock is cumulative, the accumulated dividends must also be paid along with the current dividends before common-stock dividends are paid.

Another right of preferred stockholders is that they have priority to the claims of common stockholders in the event of a corporate liquidation. This means that preferred shareholders may recover at least the par value, or the stated value, of their preferred shares before any common-stock shareholder may assert a claim to the liquidated assets. In addition, while preferred stockholders generally do not have the voting rights of common-stock shareholders, some preferred shares are issued with special voting preferences akin to the voting rights of common stock. These voting rights may enable preferred stockholders to vote to elect the board of directors or in specific rare circumstances, for example when new shares are being issued or when a taregt company’s acquisition is being approved, just as common shareholders are routinely entitled to vote. Yet another right of preferred stockholders is that because preferred shares typically involve protective provisions that prevent new preferred shares with a senior claim to the corporation’s assets from being issued, preferred shareholders do not have to face the prospect of a new stock being issued that would require its dividends be paid before any preferred shareholder is paid. Finally, preferred shares usually contain a call provision, which entitles the issuing corporation to repurchase the share when it chooses to do so. However, the corporation must usually repurchase the shares at a premium, thus protecting the investment of a preferred shareholder.

These basic rights represent the customary rights of preferred shareholders. However, preferred shares, like other securities, may be issued with a wide range of discretionary rights. Some corporation charters have provisions that authorize issuing preferred stock whose terms and conditions are not drafted in advance, and thus it can be decided by the board of directors when the shares are issued. These “blank check” preferred shares are frequently used as defense against takeovers in the event that another company attempts a hostile takeover of the corporation. To ward off such a potential takeover, the company may issue “blank check” preferred shares that have been assigned a very high liquidation value that must be paid in full if a change of corporate control occurs or that have specialized voting powers that enable shareholders to vote against the pending takeover attempt. Thus, potential investors who are considering investing in any company should carefully investigate all of the documents that the corporation files with the state regarding the terms of its formation. In addition, shareholders should stay abreast of any changes in the corporation’s formation or governance by attending the annual meeting and examining any correspondence issued by the corporation about possible or impending corporation actions.

Corporate Objectives in Issuing Preferred Stock

Equity Creation

There are several reasons why corporations issue preferred stock. The main reason is to raise funds to finance its business operations. The three most common means by which corporations finance their growth objectives are by issuing common stock, issuing preferred stock or by borrowing loans and accumulating other forms of debt. These forms of equity creation represent different types of corporate financing. Corporations may generate funds through two types of financing-equity financing or debt financing. Issuing securities such as common or preferred stock is a form of equity financing because it allows a company to collect funds from investors who buy shares without creating a corporate objective to repay the debt. This is because common and preferred shareholders generally are not guaranteed a profit or repayment at a fixed rate, but receive dividends only on the company's earnings and only if the board of directors approves a dividend distribution. On the other hand, generating corporate debt in the form of commercial-bank loans or issuing bonds is the most common form of debt financing.

Debt financing, unlike equity financing, does require that the corporation repay the debt plus any accrued interest. Thus, a corporation may choose equity financing to fund its growth by issuing preferred stock without incurring certain repayment obligations. However, the sale of preferred stock does not mean a corporation receives an influx of capital without incurring any ensuing obligations to shareholders. As explained above, preferred shareholders do have a right to preference in the event of any dividend distributions and a prior claim to the company's assets in the event of liquidation that must be paid before any common-stock shareholder is paid. In addition, corporations that pay timely dividends become an attractive investment for potential shareholders, thus creating an incentive for corporations to declare dividend distributions, which protects the investment of its shareholders.

Minimize Repayment Obligations

As explained in the previous section, companies issue stocks, such as preferred stocks, instead of generating debt through commercial-bank loans or issuing bonds to minimize inflexible repayment obligations. Preferred shareholders have no general right to receive distributions. However, preferred stock is less risky than common stock because once a distribution is lawfully declared, preferred shareholders generally are treated as creditors of the corporation and their claim to the distribution takes priority to claims of any common-stock shareholders. Since preferred shares do not require periodic dividend distributions, if the company is in a tight financial spot, it can skip paying dividends to preferred stockholders while it could not skip a payment to a creditor or to bondholders. This is why companies may decide to issue preferred stock during a period of financially difficulty. The sale of preferred shares generates corporate equity when the company needs an influx of funds without obligating it to a set repayment schedule that bonds and other forms of debt require. Thus, issuing preferred stock is a means of creating equity while minimizing corporation repayment obligations.

Control Corporate Governance

Not all companies may issue preferred stock to create equity. Only those companies organized as corporations may issue stock. This is because other types of companies, including sole proprietorships and limited partnerships, have a different ownership structure. Corporations are business entities that are owned by shareholders, while sole proprietorship or limited partnership structures are owned by either a sole proprietor or partners, respectively. The owners of the corporation become its owners by purchasing shares of the corporation's stock.

There are a number of reasons why a company may decide that becoming a corporation is the best course of action. The first reason is that incorporation affords a company the right to issue stock to create equity for its business objectives. Second, incorporation separates the company’s identity, legal standing and assets from its owners. This means that, in general, the owners of a company cannot be personally sued or their assets taken if the company is sued for any corporate wrongdoing. This concept, known as limited liability, is a way for owners to protect their personal assets so that if the company is sued or faces bankruptcy, the owners will not face the potential loss of their personal assets.

However, once a corporation is formed, it may pursue its goals of creating equity by issuing stock either to a select group of individuals or to the general public. The corporation may issue a number of different types of securities, including common stock or preferred stock. A company may decide to issue preferred stock for several reasons. First, dividend payments to preferred shareholders may be suspended at the discretion of the board of directors in the event of a company’s financial problems. Second, issuing preferred stock enables the current ownership of a corporation to retain some control over its corporate governance. Some companies may decide to limit the shares of stock the corporation will issue to the founders of the company or to its employees. These companies are called “private” companies because their stock is held privately by a defined group of individuals, and thus is not able to be purchased by the public on any of the securities exchanges.

All corporations are initially formed as private entities, and this enables corporate founders to keep control over a company's initial growth and profits. However, private owners may later decide to raise funds to finance the company's growth by offering the public an opportunity to share in the ownership of the company by purchasing shares of its stock. This process changes a company from being a privately held corporation to being a publicly held company. The actual opportunity by which public investors are offered the opportunity to buy stock in a formerly private company is called an initial public offering.

Companies choose to undergo an initial public offering to expand operations, finance existing debt, build a new product or pay for a new project. When a company goes public, the company’s founders can decide which type of stock to offer investors. Private companies often choose to issue preferred stock in the initial public offering in order to maintain some form of control over the corporation’s governance. Since preferred stock does not generally carry the right to vote as common stock does, the issuance of preferred stock enables the company’s founders to keep stockholders’ economic interests in the company separate from the day to day business operations. Thus, a private company may choose to issue preferred stock in lieu of common stock so that its founders to not have to make concessions with the votes of shareholders as would be the case if common-stock shares were issued. Issuing preferred stock, therefore, allows a company to create equity while protecting its founders’ interest in maintaining some form of control of its governance.

Applications

Factors That Affect the Value of Preferred Stock

Stock Splits

A corporation whose stock is performing well may decide to divide its existing shares into multiple shares and distribute the additional, newly created shares to existing shareholders in proportion to the multiple of the split. For instance, a commonly used split is a two-for-one increase wherein each share is divided into two units, giving each stockholder an additional share for each share the investor currently holds. However, stocks can be split in other ways such as two-for-one, five-for-one, or any multiple that the company approves.

Many investors assume that a stock split automatically increases the value of the stock. However, this is not always the case. When a stock splits, the price per share also drops so that the value of the stock stays relatively stable. While the mechanics of the stock split may not have a significant effect on the value of a stock, the collective psyche of the investors in the market may impact the stock's value. This can happen if, for instance, a profitable company with high-priced shares splits its stock so that the price of its shares drops. When this happens, the stock becomes more affordable and thus more attractive to the average investor, allowing more investors to purchase more shares of the company. This drives the value of the stock up so that investors have not only more stocks, but more stocks that have increased in value. In addition, a stock split is generally announced in the media, and this draws attention to the stocks as an investment opportunity and signals to investors the confidence of the company's management that the corporation will be profitable in the months and years ahead.

Stock Repurchase Programs

A stock repurchase program, or also referred to as a buyback, occurs when a corporation repurchases or buys back shares of stocks that it previously issued. When a corporation repurchases its own stock, it takes those shares out of circulation and thus reduces the number of shares of corporate stock that are outstanding. The effect of a buyback is that each shareholder suddenly owns larger percentage of the company.

There are a number of reasons why companies might choose to repurchase stock. First, a corporation may be striving to raise its price to earnings ratio in that with fewer shares in the market, each share generates more earnings, and this boosts the earnings per share ration. In addition, a corporation may repurchase shares of its stock to offer the shares as an incentive to employees or management. Also, a corporation’s management may announce a stock repurchase program to signal that it believes the company’s stock is undervalued and will increase in value because it is optimistic about the company’s future. However, investors must research a stock repurchase program carefully because when a company’s shareholders vote to authorize a buyback, the corporation is not obligated to follow through with the buyback. Some companies, then, may announce buyback plans to boost the perceived value of its stock without retaining any intention to actually repurchase shares of its stock. Thus, a stock repurchase program can either be a form of posturing by the company or it can be carefully conceived profit-making effort that is actually implemented by a corporation. In either case, stock repurchase programs can have an effect on the value of preferred stock.

Risk

Risk is an element of any investment that must be considered but that is hard to quantify. When a company sells stock, investors who purchase shares risk the possibility that the company may not make money in exchange for the ability to receive dividends if the company is profitable. Thus, companies sell stock to make money in the form of corporate financing and investors buy stock to make money in the form of dividends that enhance the net worth of their investment portfolios. But, with the possibility of making money comes its opportunity cost, or what the company and its investors must forge in order to have the ability to make money. When corporations sell their stock to raise capital, they must relinquish some of the corporation’s earnings by paying dividend distributions and some control of the corporation’s governance to shareholders who may be given the right to vote on corporate activities. When investors buy stock and become shareholders, they give up money they currently have in order to gain the possibility of participating in the distribution of a company’s earnings and a say in how a company is run.

Preferred shares are similar to common stock in that they both symbolize an ownership unit of a company. Any investment in a company’s stock comes with a certain amount of risk because shareholders are not guaranteed that a corporation will be profitable. However, preferred stock is considered to be a less risky investment than common stock because preferred shares are generally allocated larger dividend payments than common-stock shares and because the dividends of preferred shares are typically guaranteed by the corporation while common shares are not guaranteed dividend payments. Thus, if a company’s profits fall, the company may pay dividends to preferred stockholders but not to common stockholders in order to save money. Also, in the event of liquidation, preferred stockholders have a higher priority in their claim to the company’s assets than do common shareholders. In sum, preferred shares offer risks and benefits to both an issuing corporation and to investors, and both sides must carefully weigh the pros and cons of their financial goals in order to decide the best course of action to take.

Conclusion

Preferred stock is an attractive means to create equity for corporations and to create wealth and corporate ownership for investors. While preferred shares may not experience the price appreciation or voting rights of shares of common stock, preferred stock is considered a solid investment. This is because preferred stockholders have rights that offer some protection for their investment, such as the fact that preferred shares are generally guaranteed a regular dividend while shares of common stock are not. In addition, preferred stockholders have preference when a dividend payout is authorized so that preferred stockholders get paid before common stockholders, and preferred stockholders can take advantage of the prime distribution of a company’s liquidated assets while common shareholders may not raise a claim to corporate assets until all preferred stockholders have received full compensation. On the other hand, while preferred stock signify ownership in a company as does common stock, owners of preferred stock generally do not get the voting rights in corporate matters that common shareholders receive. Overall, then, preferred stock offers basic rights that prompt investors to purchase such shares. And, many corporations issue preferred stock when making an initial public offering because of the security’s favorable features.

When investors do decide to purchase shares of preferred stock, they must first make a determination as to what type and classification of shares to buy. In addition, investors must be mindful of certain factors that can affect the value of preferred stock, such as stock splits, stock repurchase programs and risk.

Terms & Concepts

Absolute Priority: The practice of creditors’ claims taking priority over shareholders’ claims during liquidation or reorganization. Shareholders only receive compensation after debtors have received their full payment.

Allocation: The systematic distribution of a limited quantity of resources.

Assets: Any item owned by an individual or a corporation that represents economic value.

Authorized Shares: Established in a company’s charter, authorized shares refers to the maximize number of stock shares that a company can issue. Shareholders can vote to change this number.

Bond: One of a series of notes that are sold to investors.

Corporation: Corporations are the most common business organization form. They are chartered by the state and provided with legal rights as an entity distinct from its owners. Corporations are marked by the limited liability of their owners, the ability to issue easily transferable stock, and continued existence as a perpetual concern.

Cumulative: If a payment (interest or dividend) on a bond or share is missed in one period, those securities are given priority when the next payment is made. These arrears must be cleared up before shareholders received dividends.

Declaration Date: The date when company directors meet to determine the date and amount of the next dividend payment. After the payment has been approved it is referred to as a declared dividend.

Distribution: The payment of a dividend or capital gain.

Distribution Period: The distribution date refers to the time span between the declaration date and the record date, which is generally a few days.

Dividend: A taxable payment announced by a company’s board of directors and distributed to its shareholder, often on a quarterly basis. Dividend payments are taken out of a company’s earnings.

Liquidate: The act of selling the entirety of company assets, paying outstanding debts, and distributing the remainder to shareholders before going out of business.

Payable Date: The date set by the company directors on the declaration date on which dividends will be paid to shareholders.

Principal Shareholder: A shareholder who owns 10% or more of a company’s outstanding shares.

Record Date: A date established by the issuing to qualify for receiving declared dividends or capital gains distributions.

Shareholder: Someone who owns stock shares in a corporation or mutual fund. In the case of corporations, shareholders have a right to declared dividends as well as voting rights in certain company situations.

Stock: An item representing ownership rights (known as equity) in a corporation, and signifying a claim to a relative share in the corporation’s assets and profits.

Stock Certificate: Documentary proof of stock ownership.

Bibliography

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Suggested Reading

Saperstein, R. (2006). Corporate cash management: Historical overview. Financial Executive, 22, 24-25. Retrieved April 17, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=22989976&site=ehost-live

Soldofsky, R. (1981). The risk-return performance of convertibles. Journal of Portfolio Management, 7, 80-84. Retrieved April 17, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=15636206&site=ehost-live

Sprecher, C. (1971). A note on financing mergers with convertible preferred stock. Journal of Finance, 26, 683. Retrieved April 17, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4656234&site=ehost-live