What is Preferred Stock?
By Lior Ronen | Founder, Finro Financial Consulting
A stock, any stock, is a claim for partial ownership of a business.
Investors buy their stocks in the company either through an exchange if it is publicly traded or from the company itself if it is privately held. Many transactions also occur in the secondary market when current shareholders buy and sell shares of the company directly without the company's involvement.
When investors buy stocks in a company, they own a certain percentage of its equity, and partial ownership comes with rights and liabilities.
These rights typically include future dividend payments, liquidation preference, and even a seat on the board of directors in some cases.
Now, let's assume that a company wants to sell some of its equity to finance its day-to-day operation. However, since this company is in its early days and hasn't generated revenues yet, investors take a significant risk.
In this situation, the company could either lend money in a traditional bank debt or private market debt or alternately offer preferred terms to a particular group of shares.
If investors purchased these specific preferred shares, they would come with a higher business claim than ordinary shares.
De facto creates two classes of shares: common shares and preferred shares. These two classes have different rights in the company and different stock prices.
What is the difference between preferred stock and common stock?
The company's employees and founders usually hold common stocks, which entitle their holders with a certain level of future dividends, voting rights, and, of course, a percentage of the company's equity.
Investors typically hold preferred shares, which entitle them to better financial terms in liquidation events and some control on the board of directors.
Preferred stock differs from common stocks in these main aspects:
Better future dividend terms. Preferred shareholders will receive a higher dividend payment per stock and before the common shareholders.
No voting rights. While preferred stock includes superior rights on many fronts compared to common shares, they usually do not have any voting rights unless negotiated separately.
Better liquidation preference. It means that preferred stockholders that own a certain percentage of the company will receive the value of that portion in the company before any other shareholders class in case of liquidation events like initial public offering (IPO), merger and acquisition (M&A), or a management buy-out (MBO) for example. In some cases, they might be entitled to receive more than 1x of their holding percentage.
Additional investment rights. Typically preferred stocks entitle their holders to additional rights in the company that could include, for example, a seat in the board of directors, dilution protection mechanisms, and Right of First Refusal (ROFR), which limits the company's ability to sell its equity.
The Par value of preferred shares is usually higher than common shares. This impacts the dividend payments, shares repurchase, and dilution.
Special Preferred Shares Terms
While preferred stocks entitle investors with preferred rights and potentially higher capital gains, they could also include unique defense mechanisms for the company. Here are a few:
1. Callable. A call option in a preferred share entitles the issuing company to purchase the stocks back (call them) in specific scenarios. This term is typically used in options and convertible debt. However, it could be used in preferred stock as well. Since the preferred stockholders own equity in the company, calling these stocks happens in cooperation with investors and approval from the board of directors. The everyday use of this term is to lower dividend yields to accommodate new and lower interest rates.
2. Convertible. A convertible option allows the company or the investor to convert preferred shares to common shares. Convertible preferred stocks are typically used to simplify a future liquidation process.
3. Voting. I wrote above that preferred shares usually don't include voting rights. However, since these are private market securities and terms are negotiated between investors and the issuer, they can agree to add voting rights to the preferred shares.
Preferred Stock vs. Convertible Debt
In some aspects, preferred shares are similar to fixed-income investments. The bond's interest payments are equivalent to the preferred shares fixed dividends. They are both impacted by the company's credit rating, and both offer some added protection to investors over the ordinary share.
Unlike angel and individual investors, venture capitalists usually purchase preferred stock and not common stocks when investing in early-stage startups to benefit from the additional rights mentioned above and narrow their risk.
However, venture capitalists can offer convertible debt or other fixed-income instruments to the company in many cases.
While preferred stock and convertible debt are two popular investment vehicles in early-stage startups, there are a few significant differences:
1. Seniority. Preferred stocks are part of the company's equity, while convertible debt is part of the company's debt. Therefore, in the event of default, all debt instruments have higher seniority than any equity instrument. However, within the equity group, preferred shares have higher seniority compared to common stocks.
2. Payments. Preferred stock dividends are paid from the company's net income, while debt interest rate payments are produced from the profit before taxes. That gives an advantage to bondholders over shareholders in the repayment schedule. However, within the equity group, there is a difference between each type of stock. Ordinary stock dividends are paid only after dividends to the preferred stockholder were paid
