Why Do Companies Use Preferred or Common Stock?
For a corporation, the right type of capital financing leads to business stability, tax savings and improved profits.Companies use preferred and common stock offerings to sell ownership rights in exchange for cash.Common and preferred shares feature different ownership rights.
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Identification
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Preferred shares have a "preferred" claim on assets over common shares. Simply put, in the event of bankruptcy, the proceeds of any liquidation goes to preferred stockholders first. When the company is solvent, preferred stock owners enjoy priority status in payment of dividends. Missed preferred dividend payments accumulate and must be paid out of earnings before any dividend payments are paid on the common shares. For flexibility in terms of making dividend payments, a corporation would choose to issue common shares.
Features
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A corporation can raise more money by offering a mix of preferred and common stock, because each is attractive to a different group of investors. Conservative investors and U.S. corporations frequently buy preferred stock because of the large dividends. Since U.S. corporations also receive IRS tax breaks on dividend income received from other American corporations, this is an added incentive to choose the more stable dividend payments of preferred stock.
Common shares are more attractive for aggressive and long-term investors. Preferred stock senior asset claims make for reduced financial risks, but also less growth potential, because preferred shares tend to be less volatile than common shares. Common share valuations closely track business performance. Consequently, common shares come with a greater potential for losses but also a greater potential for gains than the more stable preferred shares.
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Effects
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Common share ownership allows for corporate voting rights. Preferred shareholders, however, cannot vote. Theoretically, an outsider can eventually control any corporation after buying more than 50 percent of its outstanding common stock since it would have a voting majority. Therefore, management may issue preferred shares to maintain operational control.
Management may issue convertible preferred shares as part of a poison pill to discourage any potential takeover. As part of the poison pill, preferred shareholders may exchange their holdings for large amounts of common shares -- voting stock -- when one party has exceeded a set percentage ownership of the firm. In addition to diluting voting power, the extra shares would add significant costs to any takeover attempt.
Misconceptions
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While preferred shareholders have a higher claim on company assets than common shareholders, bondholder asset claims come before both common and preferred shareholders.The corporation pays dividends out of profits and is never required to pay dividends on any of its stock, common or preferred. Interest payments on bonds take priority over both common and preferred stock. If corporate debt falls into default, the corporation may face lawsuits if it fails to make its bond interest and principal payments.
Considerations
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As a current investor, you may lose money when a corporation continues to sell large numbers of preferred and common shares. When new shares are issued and sold, your business ownership percentage falls. Your earnings per share and investment value may then also decrease. The Securities and Exchange Commission (SEC) calls this process dilution.
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