Key Takeaways

  • Preferred stockholders hold ownership in a company with priority over common shareholders for dividends and liquidation proceeds.
  • Preferred shares combine features of both equity (ownership) and debt (fixed dividends), offering more predictable income.
  • They typically lack voting rights but may gain them under specific conditions, such as missed dividend payments.
  • Key types include cumulative, non-cumulative, callable, convertible, and participating preferred stock, each with unique rights and benefits.
  • Preferred stockholders often benefit from priority dividend payments, conversion options, and liquidation preferences, but they face limited upside potential compared to common shareholders.
  • These shares can appeal to risk-averse investors and are widely used in startup financing, mergers, and strategic capital structures.

Preferred shareholders definition can be stated as the owners of stock who have priority on a company's assets. 

Basics of Preferred Stock

Preferred stock is a type of ownership that receives greater demand on a company's profits and assets than common stock. 

While preferred shareholders do not typically have a right to vote in the company, they do hold the benefit of being paid dividends before common shareholders. 

Features of preferred stock include:

  • Debt, which disburses dividends in a set amount
  • Equity, which has the ability for price growth

Overall, features of preferred stock vary with each issue.

There are two types of preferred stock:

  • Cumulative
  • Non-cumulative

A cumulative preferred stock requires any accumulated dividends be paid in full before a common stockholder can receive any dividend.

Preferred shareholders come before common shareholders concerning the issuance of dividends. In addition, preferred stock usually earns more than common stock and can be issued each month or in annual quarters. 

Dividend amounts can be either fixed or based on a minimum interest rate, such as LIBOR. 

Shares based on a flexible interest rate contain elements that alter the dividend payment like using the following to calculate further dividends:

  • Common stock dividends
  • A company's earnings

Types of Preferred Shares and Their Features

Preferred stockholders may hold different types of preferred shares, each with specific terms and benefits that cater to various investment goals and corporate strategies. The most common types include:

  • Cumulative Preferred Stock: Ensures that unpaid dividends accumulate and must be paid before common shareholders receive any. This feature offers greater dividend security to investors.
  • Non-Cumulative Preferred Stock: Does not accumulate missed dividends. If a company skips a payment, shareholders lose the right to that dividend.
  • Participating Preferred Stock: Allows holders to receive their fixed dividend and a share of additional profits if the company exceeds certain financial benchmarks.
  • Callable Preferred Stock: Can be repurchased by the issuing company at a predetermined price after a specified date. This provides flexibility for the company but introduces reinvestment risk for shareholders.
  • Convertible Preferred Stock: Gives holders the option to convert their preferred shares into a set number of common shares. This is especially attractive if the company’s common stock price appreciates significantly.

These types of preferred shares give investors different levels of income stability, potential upside, and risk exposure, allowing them to match their investment preferences with company offerings.

Preferred Stock and Struggling Businesses

Companies that are unable to pay dividends to shareholders of cumulative preferred stock will be required to pay the deficit of those preferred stock dividends before paying any amount of dividend to the shareholders of common stock.

Companies that have a lot of preferred stock outstanding may choose to prioritize the stock starting with prior stock as the highest level and following with a label preference of first, second, third, and so on. 

While preferred shareholders take priority over common shareholders in the event of a company liquidation, they come second to bondholders.

Technically, preferred stock is considered a type of equity; however, it resembles a combination of both bonds and stock.

Preferred shares are considered the less risky stock option for the following reasons:

  • The dividend issuance is more predictable.
  • Credit rating organizations provide ratings for the stock.

If a company is unable to pay out dividends to a preferred shareholder, the amount is accumulated until it can be paid in the future rather than placing the company in default.

The ratings on a company's preferred stock usually rank below the company's bonds because preferred shareholders do not have the same amount of assurance as bondholders.

Dividend Policies and Tax Considerations

One of the main appeals for preferred stockholders is the steady stream of dividend income. Companies typically pay these dividends quarterly, though monthly or annual payments are also possible. The dividends are often fixed and pre-determined, making preferred shares resemble bonds in terms of income predictability.

From a tax perspective, preferred dividends may receive favorable tax treatment compared to bond interest, which is taxed as ordinary income. In many cases, qualified dividends on preferred shares are taxed at the lower capital gains rate, although this depends on the investor’s jurisdiction and the specific stock structure.

However, preferred dividends are not guaranteed. If a company faces financial difficulties, it can suspend dividend payments without triggering a default—although cumulative shareholders will still be entitled to missed payments in the future.

Voting Rights, Repurchasing, and Conversion

Typically, preferred shareholders do not have any voting power through their stock; however, some contracts offer the power to claim voting rights when dividends are not issued.

Unlike the price of common stock, the price of preferred stock rarely rises and typically does not trade for more than a few dollars of the original purchase price, often $25. 

Factors that influence the price at which preferred stock is traded include:

  • The company's credit rating
  • Whether the stock is cumulative or non-cumulative
  • The stock's level of priority
  • Whether the stock is callable 

Callable shares permit the company to repurchase the stock at a given date for par value. 

For instance, if the rate of interest declines and the dividend payment has the ability to draw attention at a lower price, a company may choose to call, or repurchase, its stock and reissue it at a lower dividend yield. 

If a company chooses not to call its stock, the shares will remain in the market for trade. 

Occasionally, convertible preferred stock is issued allowing the shareholders to exchange the stock, in the proper situation, for a certain amount of common stock.

Three possibilities of stock conversion are as follows:

  • The board of directors can choose to convert shares.
  • The investor can choose conversion.
  • The stock may include a set date of automatic conversion. 

The current market price of a company's common stock determines whether the investors will benefit from a stock conversion. 

The types of preferred stock previously mentioned are merely the most widely issued forms; ultimately, preferred stock can be established in many different ways utilizing a mix of different features. 

Provided no laws or regulations are broken, a corporation can sell preferred stock containing just about any type of conditions. 

Role of Preferred Stockholders in Corporate Strategy

While preferred stockholders often play a passive role in governance, they can have significant strategic influence in certain contexts:

  • Startup Financing: Venture capital investors often prefer convertible preferred shares because they provide downside protection (through priority dividends and liquidation preferences) and upside potential (through conversion to common stock).
  • Mergers and Acquisitions: Preferred stock can be used as a tool for raising capital while limiting dilution of control. Its terms can be tailored to attract specific investor types without granting voting rights.
  • Balance Sheet Management: Companies may issue preferred stock to strengthen their capital structure without increasing debt levels, which helps maintain favorable credit ratings.

Additionally, some preferred shares grant protective provisions—special rights that require shareholder approval before major corporate actions, such as issuing new equity or selling the company, can proceed. This ensures preferred stockholders’ interests are considered during critical business decisions.

Frequently Asked Questions

  1. Do preferred stockholders receive dividends before bondholders?
    No. Bondholders always have priority over preferred stockholders for interest payments and asset claims in liquidation. However, preferred shareholders are paid before common shareholders.
  2. Can preferred stockholders lose their dividends?
    Yes, particularly with non-cumulative preferred stock. If a company suspends dividend payments, non-cumulative shareholders lose that payment, whereas cumulative shareholders are still owed it later.
  3. Why might a company issue preferred stock instead of debt?
    Issuing preferred stock can strengthen a company’s balance sheet without increasing debt obligations. It also offers flexibility since dividend payments can be suspended without default.
  4. Are preferred shares a good investment for income-focused investors?
    Yes. Because they typically pay fixed, predictable dividends and have higher priority in liquidation, they are attractive to investors seeking steady income with moderate risk.
  5. How do convertible preferred shares benefit investors?
    Convertible preferred stock allows investors to switch to common shares if the company’s market value grows, offering potential capital appreciation while maintaining downside protection.

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