What Is Preferred Stock and How It Works

Key Takeaways

• Preferred stock blends features of equity and debt, offering fixed dividends and priority over common stock in earnings and liquidation.
• Investors may choose preferred stock for steady income, especially in rising interest rate environments or for its convertibility to common shares.
• Companies issue preferred stock to raise capital without increasing debt or diluting voting power.
• Types of preferred stock include cumulative, convertible, callable, and participating, among others.
• Preferred stock carries risks such as interest rate sensitivity, credit risk, and lack of voting rights.
• The trading market for preferred stock is less liquid and more volatile than for common stock.
• Legal compliance and structuring considerations are essential for businesses issuing preferred shares.Preferred stock is a special class of equity that adds debt features. As with common stock, shareholders receive a share of ownership in the company. Preferred stock also receives special rights, including guaranteed dividends that must be paid out before dividends to common shareholders, priority in the event of a liquidation, is listed separately from common stock, and trades at a different price than common stock.

Why Is Preferred Stock Important?

Preferred stock gives you a financing alternative to taking on debt. You generally maintain greater control over your company than if you issue new common shares.

You can also remain flexible for future financing rounds by keeping debt off of your balance sheet and retaining a call option. The call option allows you to reduce your outstanding equity and offer a greater portion of your company.

Who Buys Preferred Stock and Why

Preferred stock is often favored by institutional investors such as pension funds, insurance companies, and mutual funds. These entities seek stable, predictable income streams and prefer the consistent dividend payments offered by preferred shares.

Retail investors may also be attracted to preferred stock as a way to generate income with less volatility than common stock, particularly in low-interest-rate environments.

Key reasons investors choose preferred stock include:

• Fixed dividend income similar to bond interest
• Higher claim on assets than common stockholders
• Portfolio diversification with hybrid characteristics of debt and equity
• Potential for conversion into common stock (in the case of convertible preferred)

Preferred Stock Features

Preferred stock may carry optional features that benefit either the company or shareholders. These are set out in the initial preferred stock agreement.

• Callable: A call option gives you the right to repurchase preferred shares at a fixed price or par value after a set date. You have sole discretion whether to exercise the option.
• Cumulative: You may retain the right to suspend payment of dividends. If preferred stock is designated as cumulative, the suspended dividends accumulate, and you must later pay them in full.
• Participating: A participating feature gives preferred shareholders the right to receive a share of dividends paid to common shareholders. This is in addition to preferred dividends.
• Convertible: Convertible preferred shares may be exchanged for common shares. This may happen at the option of the company, the shareholder or based on certain financial conditions.
• Voting: Most preferred shareholders have no voting rights under normal circumstances. Special voting rights may apply when dividends are suspended or the company is in financial distress. This provides additional protection to preferred shareholders.
• Adjustable Rate: The dividend rate may vary based on external factors. This provides protection against changes in inflation or interest rates.
• Preference: If the company has multiple issues of preferred stock, the preferred stock may be ranked by priority with the highest being prior, followed by first preference, second preference, etc.
• Trust Preferred Stock: A form of preferred stock that can act as debt from a tax perspective, but is seen as common stock on the balance sheet

Types of Preferred Stock

There are several categories of preferred stock, each tailored to investor needs and issuer goals:

• Cumulative Preferred Stock: Accumulates unpaid dividends to be paid out before common stock dividends.
• Non-Cumulative Preferred Stock: Does not accumulate unpaid dividends if missed.
• Participating Preferred Stock: May receive additional dividends if the company achieves certain profits or pays out to common shareholders.
• Convertible Preferred Stock: Can be exchanged for a specified number of common shares, offering capital appreciation potential.
• Callable Preferred Stock: Can be repurchased by the issuer at a predetermined price after a set date.
• Perpetual Preferred Stock: Has no maturity date and provides dividends indefinitely.
• Adjustable-Rate Preferred Stock (ARPS): Pays dividends that are adjusted periodically based on a benchmark interest rate.

Reasons to Consider Using Preferred Stock

Companies typically issue preferred stock for one or more of the following reasons:

• To avoid increasing your debt ratios; preferred shares count as equity on your balance sheet
• To pay dividends at your discretion
• Because dividend payments are typically smaller than principal plus interest debt payments
• Because a call feature can protect against rising interest rates
• Because preferred stock is generally purchased by institutional investors who make large investments
• To preserve voting rights and control over your company
• To avoid diluting shares earned with sweat equity

When Preferred Stock Is Most Effective

Preferred stock can be especially beneficial in the following scenarios:

• Rising interest rate environments: Issuing preferred stock with a fixed dividend can be more cost-effective than floating-rate debt.
• Startups or private companies: Preferred stock can be structured to attract investors while maintaining founder control.
• Highly leveraged firms: Raising equity without affecting debt ratios.
• Companies planning IPOs: Preferred stock may serve as a transitional security prior to issuing common shares.

Reasons to Consider Not Using Preferred Stock

If you have any of the following concerns, you may wish to issue common shares or equity instead.

• Dividends paid are not tax-deductible.
• Preferred shares have limited potential to appreciate in value. Investors may not pay as much as they would for common shares.
• Common shareholders can't receive dividends until preferred dividends are paid in full. This includes accumulated dividends under a cumulative feature. Payments to shareholders and key employees above reasonable salaries may legally be considered dividends.
• Common shareholders receive lower priority than preferred shareholders in the event of a liquidation.
• Some states may impose a tax based on the number of authorized or outstanding shares. There is typically no tax on debt offerings.

Potential Risks for Investors

Although preferred stock offers unique benefits, it also carries certain risks:

• Interest rate sensitivity: Prices of preferred shares can fall when interest rates rise, as newer issues may offer higher dividends.
• Credit risk: If a company faces financial hardship, dividend payments may be suspended.
• Limited price appreciation: Unlike common stock, preferred shares generally do not rise significantly in value.
• Call risk: Callable preferred stock may be redeemed early, limiting income if interest rates drop.
• Liquidity risk: Many preferred shares are thinly traded, making it difficult to buy or sell at desired prices.

How Preferred Stock Works

Preferred shares are issued in a similar manner to common shares. Investors purchase shares at the offering price, and the company receives the funds. The terms of the offer include whether any of the features listed above apply.

While preferred stock is outstanding, the company must pay dividends. The dividend may be a fixed dollar amount or based on a metric such as profits. Common shareholders may not receive dividends unless preferred dividends have been fully paid. This includes any accumulated dividends.

Investors generally have the right to buy and sell preferred shares in the public or private stock markets. The company may also repurchase shares at the current market price if the investor agrees to the sale.

The company may repurchase the shares without the investor's consent if the stock is callable. A small number of preferred stock agreements have a maturity date, at which time the company must repurchase the shares from the investors.

If the company goes out of business and is liquidated, debt holders will be repaid first. Next, preferred shareholders will receive any outstanding dividends. Preferred shareholders also have priority over common shareholders in any remaining equity. The preferred shareholder agreement sets out how remaining equity is divided. Preferred shareholders may receive a fixed amount or a certain ratio versus common shareholders.

Preferred Stock vs. Common Stock

Understanding the differences between preferred and common stock helps clarify their distinct roles:

Preferred stock offers more stability and less risk, while common stock offers greater long-term growth and voting power.

Steps to Issue Preferred Stock

Preferred stock is a formal securities offering. You must follow all applicable securities regulations. Your options include the following:

• A private offering under Section 4(a)(2) of the Securities Act and Rule 506(b) of Regulation D
• An intrastate offering under Section 3(a)(11) of the Securities Act
• An offering that meets one or more of the Regulation D exemptions; these are related to the amount of funds raised and the sophistication of your investors
• An offering in compliance with the JOBS Act made to either accredited investors or on an equity crowdfunding platform

Tax Treatment of Preferred Stock

From a corporate perspective, dividends paid on preferred stock are not tax-deductible, unlike interest on debt. However, corporate investors may benefit from the Dividends Received Deduction (DRD), which allows them to exclude a portion of dividend income from taxable income. This tax advantage is not available to individual investors.

It’s important for both issuers and investors to understand how preferred dividends are taxed, especially in relation to qualified dividend status and potential tax efficiency compared to debt instruments.

Work With a Lawyer

Because of the complexity of preferred stock agreements and securities compliance requirements, you should seek legal advice before issuing preferred shares. UpCounsel's experienced securities lawyers are available on-demand to help with your preferred stock offering. Search for a lawyer near you now.

Frequently Asked Questions

What is preferred stock in simple terms? Preferred stock is a type of equity that pays fixed dividends and gives holders priority over common shareholders in dividends and liquidation.

How does preferred stock differ from common stock? Preferred stock generally lacks voting rights but offers fixed dividends and higher priority in company earnings and assets than common stock.

Can preferred stock increase in value? Yes, but typically less than common stock. Some preferred shares are convertible, offering upside potential through conversion into common shares.

Who typically invests in preferred stock? Institutional investors, such as insurance companies and pension funds, often invest in preferred stock for reliable income and tax benefits.

Is preferred stock considered equity or debt? Preferred stock is technically equity but has characteristics similar to debt, such as fixed dividend payments and seniority over common stock in claims.