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
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 (5,000 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...
(The entire section is 5194 words.)