There are several reasons why a company chooses to offer preferred stock, all of which relate to the financial advantages that it provides. Companies offering preferred stock include Bank of America (BAC), Georgia Power Company (GPJA) and MetLife (MET).
Understanding Preferred Stock
Preferred stock derives its name from the fact that it carries a higher privilege by almost every measure in relation to a company's common stock. Preferred stock owners are paid before common stock shareholders in the event of the company's liquidation. Preferred stockholders enjoy a fixed dividend that, while not absolutely guaranteed, is nonetheless considered essentially an obligation the company must pay. Preferred stockholders must be paid their due dividends before the company can distribute dividends to common stockholders. Preferred stock is sold at a par value and paid a regular dividend that is a percentage of par. Preferred stockholders do not typically have the voting rights that common stockholders do, but they may be granted special voting rights.
Raising Capital Through Preferred Stock
Preferred stock provides a simpler means of raising substantial capital than the sale of common stock does. The par value at which companies offer preferred stock is often significantly higher than the common stock price. Because institutional investors receive tax advantages that retail investors don't get, institutions are more typically the primary buyers of preferred stock. The larger amount of capital available to institutions enables them to purchase large blocks of preferred stock.
These large investors can exclude 50% of the dividend income on their corporate tax returns. Individual investors do not get this tax break. Also, the issuer does not receive the same tax benefit they would if they had issued a bond.
This access to capital allows the company to obtain a substantial amount of equity more easily from each stock sale. Companies often offer preferred stock prior to offering common stock when they have not yet reached a level of success that would make them sufficiently attractive to large numbers of retail investors. The sale of preferred stock then provides the company with the capital necessary for growth.
Flexibility of Preferred Stock
Preferred stock also offers companies some financial flexibility. Dividends owed to preferred stockholders can be deferred for a time if the company should experience some unexpected cash flow problems. The deferred dividends are essentially considered to be owed to the preferred stockholders, payable at some point in the future, but their deferral may be critical in helping a company bridge the gap over a period of financial difficulty. This is one way in which preferred stock is distinguished from bondssince a company not making the interest payment due on a bond would ordinarily be considered to be in default and, therefore, risk bankruptcy.
The nature of preferred stock provides another motive for companies to issue it. With its regular fixed dividend, preferred stock resembles bonds with regular interest payments. Like bonds, preferred stock is rated by credit agencies. However, unlike bonds that are classified as a debt liability, preferred stock is considered an equity asset. Issuing preferred stock provides a company with a means of obtaining capital without increasing the company's overall level of outstanding debt. This helps keep the company's debt-to-equity (D/E) ratio, an important leverage measure for investors and analysts, at a lower, more attractive level.
Preferred stock is sometimes used by companies as a takeover defense by assigning very high liquidation value for the preferred shares that must be paid off if the company is taken over.
