Why Would a Company Use Preferred Stock Instead of Common Stock?
Corporations sell stocks and bonds to raise financing. Stock equity may be classified into either preferred or common shares. Corporations typically issue preferred shares instead of common stock for control purposes. Work to understand corporate finance basics so that you may appreciate the unique relationship between corporate management and its preferred and equity shareholders.
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Identification
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Preferred shares feature superior asset claims relative to common stock. In bankruptcy, preferred shareholders must be paid first from any cash proceeds from liquidated assets. Further, preferred dividends are to be paid before common stockholders receive any dividend payments. Because of these specifications, conservative investors covet preferred shares for the safety and size of their dividend payments. Meanwhile, common shares offer more potential for large capital gains. Capital gains describe the appreciation between buying and selling prices for shares of stock.
Features
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Common shareholders are awarded with voting rights, where one share generally represents one vote. Preferred shareholders, however, cannot vote. Management may elect to issue preferred shares to avoid potential conflict of interests and instability.
Common shareholders use their voting authority to elect a board of directors, who in turn, hire management to run operations for the firm. Because common shareholders are often interested in maximizing capital gains, this group is more likely to propose aggressive measures to grow long-term corporate profits. Aggressive policies, such as taking on debt to finance expansion, may be in sharp contrast to the best interests of bondholders and management. Bondholders would be concerned that the company is taking on too much debt, which jeopardizes their interest payments. Additionally, corporate executives may fear for their jobs, if common shareholder expansion plans deteriorate into sharp losses.
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Considerations
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Corporations also issue convertible preferred shares as part of poison pill plans, which are designed to thwart hostile takeovers. Hostile takeovers occur when outside investors make unsolicited bids and purchases to acquire 100 percent of the corporation's outstanding stock. Prior to 100 percent ownership, outsiders can effectively control any corporation by owning more than 50 percent of its common stock and votes. Poison pills work by allowing convertible shareholders to exchange their positions for large numbers of common shares, when one particular investor's ownership stake exceeds a set percentage of the corporation's outstanding shares. At that point, the conversion provisions translate into larger numbers of outstanding common stock, and significantly increased costs for any acquisition.
Misconceptions
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Despite their differences within corporate structure, preferred and common dividend payments follow the same tax guidelines. Contrary to bond interest, dividend payments are not tax-deductible expenses for corporations. Preferred and common stock cash dividends are paid out of after-tax net income.
Risks
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Corporations the are perceived to maintain excessive levels of management control with preferred shares are often unattractive to prospective investors. The company can become obsolete, as management guards itself against outside change. Further, poison pills may be detrimental to shareholder returns. Poison pills increase common shares outstanding, which dilutes the amount of earnings available per share of common stock. Besides dilution, a proposed takeover could actually improve shareholder returns after buyouts and management changes are complete.
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