Preferred Stock

Preferred stock, also known as preference shares, is a type of equity security that represents ownership in a corporation having a higher claim on its assets and earnings than common stock. Preferred shareholders typically receive dividends before common shareholders and have a higher claim on assets in the event of liquidation. This type of stock blends features of both equity and debt.

Characteristics of Preferred Stock

  1. Dividend Priority: Preferred shareholders are entitled to receive dividend payments before any dividends are issued to common shareholders. These dividends are often fixed and paid at regular intervals.

  2. Fixed Dividends: Dividends on preferred stock are typically set at a fixed rate, which means the payouts do not fluctuate with the company’s earnings as they might with common stock.

  3. Par Value: Preferred stock often has a par value, which is the face value or the nominal value of the share. The dividend for preferred stock is typically a percentage of this par value.

  4. Cumulative vs Non-Cumulative:
    • Cumulative preferred stock ensures that if a company does not pay dividends in one period, the unpaid dividends carry over to the next period and must be paid out before common shareholders receive dividends.
    • Non-cumulative preferred stock does not have this feature. If a company skips a dividend payment, these shareholders have no right to claim the forgone dividends in the future.

  5. Convertible Preferred Stock: These shares can be converted into a fixed number of common shares, usually at the discretion of the shareholder.

  6. Callable Preferred Stock: Callable preferred shares can be bought back by the issuing corporation at a predetermined price after a specified date.

  7. Voting Rights: Preferred shareholders typically do not have voting rights, making this stock less attractive to investors who desire a say in corporate governance.

  8. Liquidation Preference: In the event of liquidation, preferred shareholders have a higher claim on the company’s assets than common shareholders but remain subordinate to bondholders.

Advantages and Disadvantages

Advantages:

  1. Income Stability: The fixed dividend payments provide a more stable income stream than common stock dividends, which can be irregular.

  2. Higher Claim on Assets: Preferred shareholders have a higher claim on the assets of a company during liquidation, thus offering more security compared to common shareholders.

  3. Conversion Features: The option to convert shares into common stock provides the potential for capital appreciation in addition to the regular fixed dividends.

Disadvantages:

  1. Limited Upside Potential: Preferred shares do not benefit from the company’s profitability as much as common shares do. If a company experiences significant growth, preferred shareholders may miss out on substantial capital gains.

  2. Interest Rate Risk: Because dividends are often fixed, preferred stocks are highly sensitive to interest rate changes. If interest rates rise, the fixed dividend becomes less attractive compared to new issues, leading to a drop in the stock’s value.

  3. Lack of Voting Rights: Preferred shareholders typically have no voting power, limiting their influence over corporate decisions.

Types of Preferred Stock

Preferred stock can come in various types, each with unique features designed to meet the needs of different investors:

  1. Adjustable-Rate Preferred Stocks (ARPS): These shares have dividends that adjust periodically based on an underlying benchmark, like the Treasury bill rate.

  2. Participating Preferred Stock: In addition to receiving fixed dividends, shareholders may also receive extra dividends based on predetermined conditions, usually tied to the firm’s profits.

  3. Perpetual Preferred Stock: These shares do not have a maturity date, meaning the dividends are paid indefinitely unless the shares are called away by the issuing company.

  4. Fixed-Rate Preferred Stock: Dividends are set at a fixed rate and do not change over time.

Trading Dynamics

Preferred stock, while less commonly traded than common stock, finds its place on both organized exchanges and OTC markets. Institutional investors and individual income-seeking investors frequently trade preferred shares. The buying and selling dynamics differ notably from common stocks due to their fixed-income characteristics and less speculative nature.

Use in Corporate Finance

Corporations issue preferred stock as a way to raise capital without diluting the voting power of common shareholders. This can be particularly appealing in strategic financing decisions. The balance sheet will separately identify common and preferred stock under shareholders’ equity, acknowledging their distinct features and claims.

Preferred Stock in Fintech

In the Fintech space, preferred stock plays a pivotal role in venture financing. Fintech startups often issue preferred shares to venture capital firms, granting them higher priority in earnings and liquidation scenarios while preserving the founders’ control via common stock. Convertibility clauses in preferred stock allow early investors to convert their shares into common shares if the startup performs well, offering a symbiotic benefit of security and growth potential.

Real-World Examples

Several well-known companies have issued preferred stock as part of their financial strategy:

Preferred stock serves a diverse range of objectives for both issuing companies and investors. It provides stability and priority for income-focused investors and a flexible capital-raising tool for companies. Its unique blend of debt and equity characteristics allows it to fit neatly into various investment and financing strategies.