There are several ways companies can raise funds, including stocks and bonds. Corporations can also choose which kinds of stock they offer to the public. They base that decision on the type of relationship they want with shareholders, the cost of the issue, and the need prompting the financing.
When it comes to raising capital, some companies elect to issue preferred stock in addition to common stock. However, the reasons for this strategy vary among corporations.
Key Takeaways
- Preferred shares are an asset class somewhere between common stocks and bonds, so they can offer companies and their investors the best of both worlds.
- Companies can get more funding with preferred shares because some investors want more consistent dividends and stronger bankruptcy protections than common shares offer.
- Some companies like to issue preferred shares because they keep the debt-to-equity ratio lower than issuing bonds and give less control to outsiders than common stocks.
Preferred Share Basics
Preference shares act as a hybrid between common stocks and bond issues. As with any produced good or service, corporations issue preferred shares because consumers—investors, in this case—want them. Investors value preference shares for their relative stability and preferred status over common shares for dividends and bankruptcy liquidation. Corporations mostly value them as a way to obtain equity financing without diluting voting rights and for their callability. Preferred stocks are also occasionally useful to firms trying to fend off hostile takeovers.
Although preferred share prices are more stable than common stocks, they are also much less stable than investment-grade bonds.
In most cases, preference shares comprise a small percentage of a corporation's total equity issues. There are two reasons for this. The first is that preferred shares are confusing to many investors (and some companies), which limits demand. The second is that common stocks and bonds are generally sufficient options for financing.
Why Investors Demand Preference Shares
Most shareholders are attracted to preferred stocks because they offer more consistent dividends than common shares and higher payments than bonds. However, these dividend payments can be deferred by the company if it falls into a period of tight cash flow or other financial hardship. This feature of preferred stock offers maximum flexibility to the company without the fear of missing a debt payment. With bond issues, a missed payment puts the company at risk of defaulting. That would cause a credit downgrade and could even force a bankruptcy.
Some preferred shareholders also have the right to convert their preferred stock into common stock at a predetermined exchange price. In the event of bankruptcy, preferred shareholders receive company assets before common shareholders.
Why Corporations Supply Preference Shares
Companies that offer preferred shares instead of issuing bonds can accomplish a lower debt-to-equity ratio. That allows them to gain significantly more future financing from new investors. A company's debt-to-equity ratio is one of the most common metrics used to analyze the financial stability of a business. The lower this number is, the more attractive the company looks to investors. Additionally, bond issues can be a red flag for potential buyers. The strict schedule of repayments for debt obligations must be maintained, regardless of the company's financial circ*mstances. Preferred stocks do not follow the same guidelines of debt repayment because they are equity issues.
Corporations also might value preference shares for their call feature. Most, but not all, preferred stock is callable. After a set date, the issuer can call the shares at par value to avoid significant interest rate risk or opportunity cost.
Although common stock is the most flexible type of investment offered by a company, it gives shareholders more control than some business owners may feel comfortable with. Owners of preference shares do not have normal voting rights. That allows a company to issue preferred stock without upsetting controlling balances in the corporate structure. Common stock provides a degree of voting rights to shareholders, allowing them an opportunity to impact crucial managerial decisions. Companies that want to limit the control they give to stockholders while still offering equity positions in their businesses may, therefore, turn to preferred stock.
Finally, some preference shares act as "poison pills" in the event of a hostile takeover. They often take the form of a detrimental financial adjustment with the stock that can only be exercised when controlling interest changes.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial professional to determine a suitable investment strategy.
FAQs
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.
Why do companies issue preferred shares compared to common shares? ›
Common stock is different from preferred stock in case of bankruptcy. Preferred stock receives preferential treatment, meaning, those stockholders are paid first if there are any assets left to liquidate when a company goes under. Common stockholders are only paid after preferred stockholders are paid.
What would be the advantage of issuing them preferred stock instead of common? ›
Owners of preference shares do not have normal voting rights. That allows a company to issue preferred stock without upsetting controlling balances in the corporate structure. Common stock provides a degree of voting rights to shareholders, allowing them an opportunity to impact crucial managerial decisions.
Why are preferred shares better than ordinary shares? ›
The main difference between preferred and common stock is that preferred stock gives no voting rights to shareholders while common stock does. Preferred shareholders have priority over a company's income, meaning they are paid dividends before common shareholders.
Why does a company issue preference shares to its shareholders as opposed to ordinary shares? ›
Preference shares usually come with no voting rights at meetings but they provide an advantage over ordinary shareholders when it comes to receiving dividends, as preference shareholders get preference over dividends whether the business is operating or enters into liquidation in future.
Why would a company want to issue preferred stock? ›
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.
Which is better, preferred or common stock? ›
Is Preferred or Common Stock a Better Investment? Each type has pros and cons. Common stock tends to offer higher potential returns, but more volatility. Preferred stock may be less volatile but have a lower potential for returns.
What are the cons of preferred shares? ›
The main disadvantage of owning preference shares is that the investors in these vehicles don't enjoy the same voting rights as common shareholders. 1 This means that the company is not beholden to preferred shareholders the way it is to traditional equity shareholders.
What is one benefit of preferred shares that is not provided by common shares? ›
Preferred stock often provides more stability and cash flow compared to common stock. Therefore, investors looking to hold equities but not overexpose their portfolio to risk often buy preferred stock. In addition, preferred stock investors receive favorable tax treatment.
Why would a company convert preferred stock to common stock? ›
When a company holds its initial public offering (IPO), it is expected that all outstanding preferred stock will convert to common stock immediately before the IPO. This is because the underwriters (the investment banks) managing the company's IPO will require it.
There Are No Voting Rights For Preference Investors
The key disadvantage of owning preferred shares is the absence of ownership rights in the business. From an investor perspective, the business is not liable to preferred shareholders as opposed to equity shareholders.
Why do shareholders invest in preferred shares? ›
The rights of preferred shareholders
Preferred shareholders do not have voting rights, but they have a priority claim on dividends and company assets vs. common shareholders. This makes preferred stock attractive to investors looking to manage volatility in their portfolio.
Why is preferred stock more risky? ›
Since preferred stock comes with a fixed dividend yield, they are highly sensitive to interest rates. If market-wide interest rates rise above the yield of a preferred stock, it will become harder to sell that stock on the market, and investors would have to accept a steep discount if they wish to sell.
Why might an investor purchase preferred stock instead of common? ›
Preferred stocks pay a fixed dividend to shareholders, are prioritized in the event of bankruptcy, and are less impacted by market fluctuations than common stock. Preferred stocks are typically purchased for their consistent dividend payments, which offer less financial risk to shareholders than common stock.
What are the benefits of preference shares? ›
Steady income: Preference stocks offer a predictable income stream through fixed dividends, making them attractive for income-focused investors. Prioritised returns: In cases of financial distress or liquidation, preference shareholders enjoy a priority in receiving their capital back, offering a level of security.
Do preferred shares dilute ownership? ›
For private companies, preferred shares are most often issued to angel investors, early-stage venture capital firms, or other institutional investors that seek to protect their existing ownership percentage (i.e., anti-dilution rights).
What are the advantages of preference shares to the company? ›
Benefits Of Preference Shares
If the company turns a profit, the dividends are paid on some types of preference shares. This generally permits for the aggregation of dividends that are unpaid. The preferred shareholders get priority when it comes to remitting unpaid dividends, over common shareholders.
Why might an investor prefer Adita's preferred stock over its common stock? ›
Why might Adita want to issue preferredstock instead of common stock? Preferred stock sometimes includes a preference for receiving dividends and assets in liquidation. If the investor believes that the company's common stock is too risky or that the expected return on common stock is too low.
What are the disadvantages of issuing preferred stock? ›
For your investors, preferred stock can limit their upside potential, as preferred stockholders do not share in the company's growth or appreciation. Preferred stock can also expose them to dilution risk, as you can issue more shares or convert preferred stock to common stock without their consent.
