Preferred stock is a type of security that carries investor preference rights on interest, dividends, and liquidation over common stockholders. They are similar to bonds because they pay fixed coupon rates on a par value. A preferred stockholder also receives a higher dividend yield than those with common stock shares.
This web page also discusses preferred stocks.
Advantages of Preferred Stock
From an investor’s perspective, there are several advantages to investing in preferred shares. However, the issuing company may want to consider how it impacts them before offering them as they are generally considered more advantageous for investors.
We’ve outlined the advantages of preferred stock below:
- Priority Payments: Preferred shareholders receive priority interest and dividend payments. Priority payments virtually guarantee higher coupon payments until the company encounters cash flow difficulties and is bankrupt.
- Reduced Default Risk: Preferred shareholders are considered senior in the company’s debt structure. This means that preferred shareholders will prioritize common shareholders in the unfortunate event of the company’s dissolution or liquidation, making preferred share risk significantly lower than common stock.
- Tax Advantages: Income from preferred stock is taxed preferentially. Certain types of preferred stock are mentioned explicitly in the tax code. Thus, dividends earned on these shares are taxed significantly lower than ordinary income.
- Convertible to Common Stock: Many preferred stocks allow investors to convert their shares to common stock. The dividend paid on these preferred shares is typically lower than on others. Therefore, investors are generally interested in investing in convertible preferred stock.
Disadvantages of Preferred Stock
While investing in preferred shares is generally considered a safe bet, it has disadvantages. Investors and issuers should always get professional legal advice if you need help determining how preferred stocks will impact your specific situation.
Two of the primary disadvantages are described below:
- Dividend Deferral Risk: Preferred shareholders have no actual claim on the company. They will only receive dividend payments after paying all senior creditors. Creditors are only senior to equity shareholders in the event of the firm’s dissolution.
- Retractability: The specific characteristics of preferred shares vary by company. However, in most cases, the shares are retractable or redeemable. Retractable means that the company can repurchase the shares. Preferred shares may be retracted if their market value exceeds the par value or redeemed if they fall below their par value, resulting in a disadvantageous trade.
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Dividend Priority of Preferred Stock
Preferred shareholders receive dividends ahead of common shareholders due to their priority. They are typically investors who want a higher level of reassurance. Common shareholders are last in the payment priority line for company assets, which means they will receive distributions after creditors, bondholders, and preferred stockholders.
Rights and Risks Associated with Preferred Stock
Preferred stockholders don’t have voting rights since they face less risk than common stockholders. Those with lower risk may not make decisions in the company’s best interests. Even in bankruptcy, preferred shareholders receive payment after bondholders but before common stockholders.
Securities law is a complex body that requires knowledge, guidance, and experience. Work with a lawyer for startups to help you make decisions, draft investment contracts, and negotiate deals. Get in contact now with an experienced legal professional from your state.
Types of Stocks
Preferred stocks are just one of the many different types. Investors should understand what they are and their unique characteristics to make sensible and meaningful decisions.
Below, we discuss eight types of stock to consider aside from preferred stocks:
- Common Stock: Common stock represents a company’s partial ownership. This stock class entitles investors to dividend distributions. Shareholders may elect a company’s board of directors and vote on company policy changes.
- Income Stocks: Income stocks generate regular income by distributing a company’s profits or excess cash to shareholders via high dividend payouts. Typically, these stocks have lower volatility and capital appreciation rates than other stocks, making them attractive for risk-averse investors seeking a steady income stream.
- Blue-Chip Stocks: Blue-chip stocks are those that are well-established and have a sizable market capitalization. They have a track record of consistently generating reliable earnings. Conservative investors may overweight blue-chip stocks in their portfolios, particularly during uncertainty.
- Cyclical Stocks: Cyclical stocks are directly linked to the economy’s performance and typically track economic cycles. They usually exhibit greater volatility. They outperform other securities when consumers have more discretionary income during solid financial periods.
- Non-Cyclical Stocks: Non-cyclical stocks operate in recession-proof industries that typically perform well regardless of the state of the economy. As a result, they usually outperform cyclical stocks, as demand for core products and services remains relatively stable.
- Defensive Stocks: Defensive stocks usually generate consistent returns across various economic conditions and markets. In addition, businesses that issue defensive stocks sell essential products and services, such as healthcare and utilities. Therefore, they are less likely to fail since they consistently generate returns.
- Initial Public Offering Stocks: Initial public offering (IPO) stocks are typically allocated at a discount before the company’s stock listing on a public exchange. They may also include a vesting schedule to prevent investors from selling their shares immediately after the IPO. As a result, market commentators often refer to newly listed stocks as IPO stocks.
- Penny Stocks: A penny stock is a security with a market capitalization of less than $5. However, some penny stocks trade on major exchanges. They also have a large spread between the bid and asking prices, so investors must place order limits on transactions.
Common Stock vs. Preferred Stock
The most significant difference between common stock vs. preferred is that preferred stocks receive payment priorities and have no voting rights. In contrast, the opposite is true for the latter. When investing in startups, investors are typically not offered common stock. Instead, investors prefer preferred stock or convertible instruments. Typically, these convertible debts, such as SAFE notes and convertible notes, change to preferred stock upon triggering events.
Here is a closer look at how common and preferred stocks are different:
- Voting Rights: Startup common stocks have voting rights while preferred stocks don’t. In some cases, each class votes separately or collectively. To avoid violations, securities lawyers can provide legal advice when engaging preferred stockholders in the voting process.
- Seniority: Seniority refers to an investor’s position in the payment priority line. When investing, you want to be as close to the front of the line as possible. This increases your chances of protecting your capital investment if the business fails. Preferred stockholders claim a company’s payout before common stockholders in this situation.
- Liquidation Preference: Liquidation preference refers to the amount paid to preferred stockholders before common stockholders. Typically, this is a multiple of the initial investment. Preferred stockholders receive their payments before common stockholders in a liquidation.
- Information Access: Investors require detailed information about a company’s financial position and operational status. Significantly preferred stockholders may be entitled to information rights for their stock purchase. The term ‘major holders’ is typically defined in a Preferred Agreement, and the definition may vary from agreement to agreement. However, we should define Major holders as investors who contribute a significant amount of capital to a startup – typically above half a million dollars.
Final Thoughts on Preferred Stock
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