Why Use Common Stock Instead of Preferred Stock?
Corporations can raise money through the sale of stocks (also known as equities) or bonds to the financial markets. In certain situations, a company might sell a special class of stock known at "preferred stock," which more closely resembles bonds than stock and is more likely to retain its value in the case of a bankruptcy.
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Preferred Stock
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Preferred stock tends to be owned by institutional investors or venture capitalists who invest in a company early in its formation. The value of preferred stock doesn't rise and fall with the market like common stock. Instead, preferred stock has a par value that resembles the face value of a bond. As with a bond, the owner receives regular payments, but these are dividends, not interest payments.
Advantages to the Issuer
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Certain ratios, such as earnings per share and debt-to-equity, are important to potential investors who are valuing a company. Whether the corporation raises money though issuing stock or bonds can affect these ratios. A company might choose to issue preferred stock to avoid adding too much long-term debt (as would be the case with bonds) or diluting shares (as would the case be common stock) for the tastes of potential investors.
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Benefits to the Investor
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The main benefit preferred stock has to the investor is that it provides stable and less risky income than common stock. If the company goes bankrupt, the assets of the company are used to pay off preferred stock investors before common stock investors. If the company is short on cash, dividends must be paid to the preferred stock investors before common stock investors, and if there isn't enough cash, it must be paid at a later date. Investors are also charged a lower tax rate for this type of investment.
Disadvantages to the Investor
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Owners of preferred stock do not have voting rights like common stock holders. Also, preferred stock does not appreciate like common stock, so the investor does not profit from a rising stock price. The exception to this is convertible preferred stock, which can be exchanged for common stock, but not back again.
Also, preferred stock with a fixed interest rate may decrease in value if the prevailing interest rate climbs, and they are more difficult to sell than bonds. Some preferred stock has a variable interest rate to solve this problem.
Poison Pill
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Some companies issue preferred stock to ward off hostile-takeover bids. A hostile takeover is when someone tries to buy a controlling interest of the common stock of a corporation. If the agreement regarding the preferred stock is written such that the preferred stock gains value after a hostile takeover, it may be very expensive for the new owners to pay off the preferred stock investors. This strategy is known as the poison pill.
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