How Callable Preferred Stock Works

Callable preferred stock is simply preferred stock that can be repurchased or redeemed by the issuer business - in this case, your business.  The issuer has the option to repurchase the stock according to terms set out in the prospectus, a special type of contract that covers an investment offering.

Callable preferred stock is the “best of both worlds,” so to speak - with callable preferred stock, you can enjoy the benefits of both equity and debt financing while avoiding the drawbacks. When you issue callable preferred stock, you can raise funds without having to make loan payments or give up a permanent stake in your company.

There are four key terms related to the issuance of preferred stock:

1. The share price is the amount each share is worth at the time of sale.  It is sometimes referred to as the “par stock value.”

Example: If you sell ten preferred shares at a $10 share price, you will receive $100.

2. The dividend rate is a fixed amount payable as set out in the prospectus.  The dividend rate is based off of the par value of the preferred stock.

Example: If there is a 5% dividend rate on $100 par value of callable preferred stock sold to a given shareholder, you will need to pay that shareholder $5 per year in dividends for the length of such ownership.

3. The call price is the pre-determined price you pay to repurchase the preferred shares. It is frequently priced higher than the original share price, and may include unpaid dividends.  When the call price is higher than the share price, the difference is known as the “call premium.” Depending on the terms of the prospectus, the call premium may decrease over time.

Example: If the call price is $11 for 10 shares, you can decide to repurchase the shares for $110 at any time on or after the call date. The shareholder cannot refuse to sell, nor can they ask for a higher price. Full ownership rights go back to you, and you no longer need to pay dividends.

If the stock would trade on the market at above the call price, then the likelihood of you benefiting from repurchasing the shares -- and therefore actually repurchasing the shares -- increases.  As such, the price appreciation of the stock is effectively capped at the call price.  This means that investor demand can be significantly cooled for callable stock when the trading price is close to or above the call price.

4. The call date is the date when you are first allowed to call preferred shares.  There is no minimum or maximum call date, though many issuers set call dates at 3-5 years after the stock has been issued.

The issuer is not required to “call” the shares after the call date.  The issuer may or may not, at their discretion.

Callable preferred stock can be saddled with any number of other requirements before repurchase or redemption is allowed.  The call date is simple a common requirement.

When the stock is called, the difference between the market value and par value of the stock is not treated as either a gain or a loss.  It is either debited to retained earnings (if there has been a loss) or credited to additional paid-in capital on the preferred stock (if there has been a gain).

Why Callable Preferred Stock Is Important

Callable preferred stock gives you control over your financing costs.

If rates fall, you can repurchase the stock at the call price and issue new shares paying a lower dividend rate.

Suppose that you issued shares at a 10% dividend rate.  Interest rates decline, however, and you can repurchase the shares and reissue them at a lower 5% dividend rate.  This gives you a great deal of flexibility to adapt to the changing market.

If rates rise, you can leave the shares outstanding and continue to pay a fixed dividend rate lower than prevailing market interest rates.

However, because callable preferred stock empowers the issuer and shifts a great deal of risk to the investor, callable stock is typically issued with a high dividend rate to account for such risk.

Reasons to Consider Using Callable Preferred Stock

Preferred stock confers several advantages compared to standard debt and equity financing. Preferred stock allows you to...

  • Avoid permanently giving up a majority interest in your company.

    • Shares can be repurchased after the call date.

  • Maintain voting control.

    • Preferred shares can be classified as non-voting shares.

  • Leave common shares available for equity incentive plans.

  • Control your funding costs.

  • Repurchase shares at a fixed price when you have surplus cash.

    • The call price for repurchasing shares is set at the time the prospectus contract is executed.

Reasons to Consider Not Using Callable Preferred Stock

Preferred stock may not be ideal for all financing situations, however.

  • Investors may not be willing to pay as much for equity subject to call.

    • The perceived value of callable preferred stock is likely to be lower as such shares have less upswing potential.  Investors who are looking to cash in significant gains on their price-appreciated callable preferred stock must do so before the issuer announces a call, as a call announcement can send share values plummeting towards par value.

    • On the other hand, “call price premiums” guarantee a return even if the markets underperform.  Some investors therefore find such an arrangement advantageous.

  • Preferred stock receives preference over common stock in the event of a liquidation or restructuring.

  • You may not pay dividends to common shareholders unless preferred shareholder dividends are paid in full.

    • This can be a problem if you have overextended yourself with high dividend rates for preferred stock shareholders.

  • Adding securities classes complicates your corporate structure and may impose additional compliance costs.

  • There are alternatives for retaining tightened ownership and control of the business.

    • You can issue stock with a right of first refusal, which allows you to match third-party offers to buy company stock from a shareholder.

Is Callable Preferred Stock Right for Your Business?

Callable preferred stock is worth considering if you're currently exploring financing options for your startup, but would like to avoid the pitfalls of standard debt and equity financing.  Repurchasing callable preferred stock is easy.  Notice must be sent to the relevant shareholders with details on the various repurchase conditions.

To get in touch with an experienced securities lawyer in your area -- who will help you decide if issuing callable preferred stock is the right move for your startup -- use the UpCounsel platform.  UpCounsel connects you directly with the best lawyers in your area and provides you with the tools necessary to find the most suitable lawyer for your budget..