Preferred stock is one of two basic categories of stock. The other is common stock. Both stock types represent an ownership stake in a company. The number of shares a company has depends on whether it is a small private company or a large public corporation. Although there are several different variations of preferred stock, the main distinctions between it and common stock relate to voting rights and order of payment to investors.
Common is the primary category of stock, and a corporation consists entirely of common stock unless the articles of incorporation expressly permit a secondary category of preferred stock to be issued. Common stock typically carries with it one vote per share, with fractional votes proportional to fractional share ownership. There can be different classes of common stock, which may have full, limited, or no voting rights. A corporation may issue Class A and Class B shares, for instance, with only Class A possessing voting rights. Common shares control the direction of the company, provide equity capital, and receive distributions at the discretion of the board of directors.
Unless expressly stated otherwise, preferred stock carries with it the same voting rights as common stock. Usually these rights are limited, special or conditional according to the articles of incorporation. Preferred shares raise additional capital while allowing the owners to maintain control of the company. Their proportional ownership stake in the company is not diluted through the issuance of additional non-voting preferred shares. Preferred shares normally receive a regular fixed dividend payment.
Articles of Incorporation
When a company incorporates, its articles of incorporation serve as the legal document detailing the makeup of its shares. The articles of incorporation determine what sort of voting rights preferred shares have. Depending on state law, there is practically no limit on the type of qualifications that may be placed on preferred stock. In addition to establishing the voting rights of preferred shares, the articles of incorporation may determine how preferred shares receive distributions, whether they can be converted to common stock, and a number of other features.
Control vs. Return
Preferred stock is a trade-off between control of a company and return on investment. A regular fixed dividend payment is usually offset by limited, conditional, or non-voting rights. Conversely, preferred shares may carry special voting rights greater than those of common shares at the expense of a lower or no fixed dividend.
When a class of shareholders, such as preferred shareholders, lacks voting rights, they are in theory at the mercy of voting shareholders. In this case preferred shareholders would be powerless to stop unfavorable changes to their rights. However, the Model Business Corporation Act, adopted entirely or in part by many states, permits a given class of shareholders to vote on matters that might directly affect that class of shares. So while preferred shareholders might not be able to vote on the members of the board of directors, they would have a say in a proposed change to the fixed dividend rate of their shares. Preferred shareholders often have conditional voting rights. If they do not receive their dividend for a set period of time such as two years, they would then receive voting rights equal to those of common shareholders. This protects the interests of preferred shareholders. If a company is not profitable and unable to pay its dividend, then preferred shareholders would obtain some control over the future direction of the company.