Preferred Dividends: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
Preferred dividends are the dividends that are accrued paid on a company’s preferred stock. Preferred shareholders have priority over common shareholders.7 min read
What Are Preferred Dividends?
Preferred dividends are the dividends that are accrued paid on a company’s preferred stock. Any time a company pays dividends, preferred shareholders have priority over common shareholders, which means dividends must always be paid to preferred shareholders before they are paid to common shareholders. If the company is unable to pay all the dividends, then claims to any preferred dividends will take precedence over claims to dividends on common shares.
Dividends are payments that a company distributes to its shareholders. Unlike the interest paid on bonds, dividend payments are not mandatory. Many startups do not pay dividends because they want to use any available money to grow the business instead.
Preferred dividends are link to preferred shares, which are a type of equity in the company, although these shareholders do not have any voting rights. They offer more predictable income than common stock, but do not enjoy the same guarantee as creditors - so even though they have a prior claim on the company’s assets if liquidated, they are still subordinate to bondholders and creditors. Most shares do not have a maturity date, and if they do, then they are quite far in the future.
What are preferred dividends worth?
Preferred dividends are paid at a fixed rate. Annual dividends are calculated as a percentage of the par value, which is the price of the preferred stock at the time it was issued. Because the par value is a fixed number and the percentage is also a fixed number, the annual dividend payments remain the same from year to year. The annual amount is then divided into periodic payments, which are typically made two to four times per year.
For example, say that a preferred stock had a par value of $100 per share and paid an 8% dividend. To calculate the dividend, you would need to multiply 8% by $100 (the par value), which comes out to an annual dividend of $8 per share. If dividend payments are made quarterly, each payment will be $2 per share. This stock would be referred to as "8% preferred stock."
Dividends on preferred stock are generally paid for the life of the stock. However, dividends are only paid when the board of directors declares them. The board always has the option to skip dividend payments, but in most cases, the company will be required to pay the preferred stock’s skipped dividends at a later date. The company has no such obligation to common shareholders.
If the company does not declare and pay a dividend to preferred shareholders, it cannot pay a dividend to common shareholders. What happens to the preferred shareholders’ payments if the company misses a payment depends on whether their dividends are cumulative or non-cumulative.
Cumulative versus Non-Cumulative Preferred Stock Payments
How preferred stock dividends are paid depends on the rights that investors negotiate with the company, and whether the dividends are cumulative or non-cumulative.
Cumulative dividends are best for investors. With these dividends, if the company decides not to pay dividends on its regular schedule, it will pay all the skipped dividends at once when the company is liquidated or when preferred shareholders redeem their shares.Therefore, the investor stands to get a lump sum at some point in the future, even if they have to forego periodic payments. If a company has several simultaneous issues of preferred stock, then they might be ranked, and paid in order of preference. The highest ranked dividend is called prior, followed by first preference, second preference, and so on. Luckily, most of the time, preferred stock is given out pretty regularly, at the same price, so investors can expect dividends on a regular basis.
The company is not allowed to pay common shareholder any dividends until it pays preferred shareholders all outstanding and current dividends.
Non-cumulative preferred dividends, by contrast, only get paid if the company pays a dividend. If the company misses a payment, the company is not obligated to make it up later. Basically, all non-cumulative stock may be disregarded, even after going into arrears. Non-cumulative preferred stock owners must still be paid the current dividend before common shareholders can be paid.
Kinds of Stock
Non-participating versus Participating Preferred Stock
Participating preferred stock is preferred stock that provides a dividend that is paid before any dividends are paid to common stockholders in a liquidation situation and a share in any remaining liquidation proceeds on a converted to common stock scenario. Non-participating preferred stock only provides a dividend that is paid before common stockholders, but no share in remaining liquidation proceeds. Most preferred stock is non-participating, meaning, shareholders get paid the stated dividends, based on a fixed percentage of the offering price, and nothing more.
Callable Preferred Stock
Companies that issue callable preferred stock may "call the stock in" -- that is, the company can buy back the stock -- after a certain date at a pre-specified price. A company is not obligated to call in the stock, but it might choose to do so if market dividend rates go down. For example, if a preferred stock has a 9% dividend rate, and the market rate drops to 7%, the company can get out of its obligation to keep on paying 9% dividends by calling in the stocks. In some cases, a company may pay the shareholders future dividends at the time it buys back the stock. If the company does not call the stock in, shares may continue to trade past their call date.
Dividend rates paid on callable preferred stock tend to be higher than the rates on non-callable preferred stock because the shareholders are giving up their right to keep their stock over the long term.
Convertible Preferred Stock
Convertible preferred stock gives shareholders the option to convert the stock to a fixed number of common shares after a pre-determined date. Dividends will typically be lower on convertible preferred stock because the option to convert the shares is a benefit to the shareholders, although it all depends on the market price of the common stock when this occurs
Why Are Preferred Dividends Important?
Preferred stock dividend rates are usually much higher than common stock dividend rates. That’s an important part of the reason why preferred stocks are “preferred.” These attractive dividends, along with guaranteed payment, make preferred stock a valuable tool for startups to use to attract investors, who otherwise might be leery of taking on the risk that comes with investing in a young company.
Disadvantages of Preferred Dividends:
In some cases, the fixed rate of dividend payments can be a disadvantage.
If a company’s earnings go up, the company may increase the dividend rate it pays to common stock shareholders. Dividend payments to common shareholders, in general, tend to go up over time. However, for most preferred shareholders, who own non-participating stock, the dividend rate will always remain the same. These shareholders don’t get the chance that common shareholders have to share in any company’s earnings that exceed the preferred dividend rate. In this way, stability is kind of a double-edged sword - where a dividend can be expected on a regular basis, but if the company takes off, preferred stockholders see no benefit.
Fixed rates can also be disadvantageous when inflation is high because the dividend rates are not adjusted for inflation. Over time, when there is inflation, the fixed dividend will lose purchasing power.
They can also be taxed at much higher rates than other dividends - sometimes as much as thirty-five percent. With that, different kinds of preferred dividends exist, with different tax consequences. True preferreds pay real dividends while trust preferreds pay interest income and are typically structured around corporate bonds. Sometimes, companies can issue both kinds of dividends, which only adds to the confusion. Trust preferreds are taxed higher, so these should only be used in things like a 401(k) or IRA since tax is a non-issue while the portfolio grows.
Companies are obligated to make up past due preferred dividend payments. However, that is not always possible. If the company goes bankrupt, and it still has past dividend payments due, it may not have the money to make those missed payments. After a bankruptcy, preferred shareholders are ahead of common shareholders in line for payment, but they are behind bond holders, who must be paid first if there is money available. If a company does not have enough money left to pay its bond holders, it won’t be able to pay its preferred stockholders.
Advantages of Preferred Dividends:
Despite some shortcomings to preferred dividends, they do offer some attractive features. Because the preferred dividend rate is fixed, it provides more stability for shareholders than common shares do. Preferred shareholders know how much money is owed to them for dividends in the future while common shareholders don’t know how much or if they will be paid at all, for dividends until the board of directors decides.
Preferred dividends typically pay a higher rate than dividends paid to common shareholders, which is one of the main benefits of these dividends. The preferred stock rates and terms are also displayed on the balance sheets of the company, while the common stock dividends are declared only after the year’s end by the board of directors. There is a lot more transparency with preferred dividends than with common stock. If a company cannot pay all of its dividends, it must pay preferred dividends before paying dividends to holders of common stock.
A company has no obligation to ever pay common shareholders dividends. By contrast, it must pay dividends to preferred shareholders (that is, if it can)
Frequently Asked Questions
- What does “in arrears” mean?
If a company does not pay a dividend on cumulative preferred stock for a particular year, that is known as “dividend in arrears.” It will be disclosed in a note on the company’s balance sheet. This is important for preferred stockholders to note, as they are now owed certain dividends.
- What is a preferred dividend ratio?
The preferred dividend ratio is a formula that equals the net income of a company divided by its required preferred dividend payouts. The higher the ratio, the less trouble the company will have in making its required dividend payments. A high ratio is good for common shareholders too because they can't get paid until preferred shareholders get paid.
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