Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior (i.e., higher ranking) to common stock but subordinate to bonds in terms of claim (or rights to their share of the assets of the company)Drinkard, T., A Primer On Preferred Stocks, and have priority over common stock (ordinary shares) in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.
Like bonds, preferred stocks are rated by major credit rating agencies. Their ratings are generally lower than those of bonds, because preferred dividends do not carry the same guarantees as interest payments from bonds, and because preferred-stock holders' claims are junior to those of all creditors.
Preferred equity has characteristics similar to preferred stock, but the term is typically used for investments in real estate or other private investments where the common stock is not publicly traded, so private equity has no public credit rating.
Features Features of almost all preferred stocks include:.
Preference in dividends Preference in assets, in the event of liquidation Callability (ability to be redeemed before maturity) at the corporation's option (possibly subject to a spens clause) Higher dividend yields Convertibility to common stock Nonvoting
Preference in dividends In general, preferred stock has preference in dividend payments. The preference does not assure the payment of dividends, but the company must pay the stated dividends on preferred stock before or at the same time as any dividends on common stock.
Preferred stock can be cumulative or noncumulative. A cumulative preferred requires that if a company fails to pay a dividend (or pays less than the stated rate), it must make up for it at a later time in order to ever pay common-stock dividends again. Dividends accumulate with each passed dividend period (which may be quarterly, semi-annually or annually). When a dividend is not paid in time, it has "passed"; all passed dividends on a cumulative stock make up a dividend in arrears. A stock without this feature is known as a noncumulative, or straight,Drinkard T. preferred stock; any dividends passed are lost if not declared..
Other features or rights Preferred stock may or may not have a fixed liquidation value (or par value) associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued.Harvard Business Services, Inc. Accessed February 23, 2007 Preferred stock has a claim on liquidation proceeds of a stock corporation equal to its par (or liquidation) value, unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim. Almost all preferred shares have a negotiated, fixed-dividend amount. The dividend is usually specified as a percentage of the par value or as a fixed amount (for example, Pacific Gas & Electric 6% Series A Preferred). Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index (such as LIBOR). Some preferred shares have special voting rights to approve extraordinary events (such as the issuance of new shares or approval of the acquisition of a company) or to elect directors, but most preferred shares have no voting rights associated with them. However, cumulative preferred shares may gain voting rights when the preferred dividends are in arrears for a substantial time; such provisions are sometimes required by corporate law (e.g. India) or stock exchange listing requirements (e.g. New York Stock Exchange).
The above list (which includes several customary rights) is not comprehensive; preferred shares (like other legal arrangements) may specify nearly any right conceivable. Preferred shares in the U.S. normally carry a call provision,According to a Quantum Online table enabling the issuing corporation to repurchase the share at its (usually limited) discretion.
Types In addition to straight preferred stock, there is diversity in the preferred stock market. Additional types of preferred stock include:
Prior preferred stock—Many companies have different issues of preferred stock outstanding at one time; one issue is usually designated highest-priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the payments on the prior preferred. Therefore, prior preferreds have less credit risk than other preferred stocks (but usually offer a lower yield). Preference preferred stock—Ranked behind a company's prior preferred stock (on a seniority basis) are its preference preferred issues. These issues receive preference over all other classes of the company's preferred (except for prior preferred). If the company issues more than one issue of preference preferred, the issues are ranked by seniority. One issue is designated first preference, the next-senior issue is the second and so on.
Convertible preferred stock—These are preferred issues that holders can exchange for a predetermined number of the company's common-stock shares. This exchange may occur at any time the investor chooses, regardless of the market price of the common stock. It is a one-way deal; one cannot convert the common stock back to preferred stock. Cumulative preferred stock—If the dividend is not paid, it will accumulate for future payment. Non-cumulative preferred stock—Dividends for this type of preferred stock will not accumulate if they are unpaid; very common in trust-preferred security (TRuPS) and bank preferred stock, since under BIS rules preferred stock must be non-cumulative if it is to be included in Tier 1 capital. Exchangeable preferred stock—This type of preferred stock carries an embedded option to be exchanged for some other security. Participating preferred stock—These preferred issues offer holders the opportunity to receive extra dividends if the company achieves predetermined financial goals. Investors who purchased these stocks receive their regular dividend regardless of company performance (assuming the company does well enough to make its annual dividend payments). If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend. Perpetual preferred stock—This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder (although there are redemption privileges held by the corporation); most preferred stock is issued without a redemption date. Putable preferred stock—These issues have a "put" privilege, whereby the holder may (under certain conditions) force the issuer to redeem shares. Monthly income preferred stock (MIPS)—a hybrid security created by Eli Jacobson, a Sullivan & Cromwell tax partner, and introduced to the market by Goldman Sachs in 1993. In essence, MIPS is a combination of deeply subordinated debt and preferred stock. MIPS is structured in such a way as to make payments on the security an interest expense for the borrower and dividend for the lender. A special purpose entity of the issuer sells the preferred stock to the public and then lends the proceeds to the parent. The parent's interest payments to the subsidiary are tax-deductible as interest and are used by the SPE to pay preferred dividends to the investors. However, the interest income received by the SPE is not taxable income, because it is organized as a tax-free entity. Because of these features, MIPS at one point dominated the market for traditional perpetual preferred equity, accounting for over 70% of all new preferred issues. However, MIPS as a tax shelter no longer works. The credit rating agencies consider MIPS to be preferred stock.
Usage Preferred stocks offer a company an alternative form of financing—for example through pension led funding; in some cases, a company can defer dividends by going into arrears with a little penalty or risk to its credit rating, however, such action could hurt the company meeting the terms of its financing contract.. With traditional debt, payments are required; a missed payment would put the company in default.
Occasionally, companies use [voting] preferred shares as a means of preventing hostile takeovers, creating preferred shares with a poison pill (or forced-exchange or conversion features) that is exercised upon a change in control. Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank checks" are often used as a takeover defence; they may be assigned very high liquidation value (which must be redeemed in the event of a change of control), or may have great super-voting powers.
When a corporation goes bankrupt, there may be enough money to repay holders of preferred issues known as "senior" but not enough money for "junior" issues. Therefore, when preferred shares are first issued, their governing document may contain protective provisions preventing the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari-passu (equal), or junior relationship with other series issued by the same corporation.
Users Preferred shares are more common in private or pre-public companies, where it is useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may either encourage or discourage the issuance of publicly traded preferred shares. In many countries, banks are encouraged to issue preferred stock as a source of Tier 1 capital.
A company may issue several classes of preferred stock. A company raising venture capital or other funding may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock. Such a company might have "Series A Preferred", "Series B Preferred", "Series C Preferred", and corresponding shares of common stock. Typically, company founders and employees receive common stock, while venture capital investors receive preferred shares, often with a liquidation preference. The preferred shares are typically converted to common shares with the completion of an initial public offering or acquisition. An additional advantage of issuing preferred shares to investors but common shares to employees is the ability to retain a lower 409(a) valuation for common shares and thus a lower strike price for incentive stock options. This allows employees to receive more gains on their stock.
In the United States, there are two types of preferred stocks: straight preferreds and convertible preferreds. Straight preferreds are issued in perpetuity (although some are subject to call by the issuer, under certain conditions) and pay a stipulated dividend rate to the holder. Convertible preferreds—in addition to the foregoing features of a straight preferred—contain a provision by which the holder may convert the preferred into the common stock of the company (or sometimes, into the common stock of an affiliated company) under certain conditions (among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share, or a certain price per share for the common stock).
There are income-tax advantages generally available to corporations investing in preferred stocks in the United States. See Dividends received deduction.