Is It Better to Issue Common Stock or Preferred Stock?

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A company may find it easier to sell common stock because of its potential to grow higher than preferred stock. The business has to bear in mind, however, that common stockholders have voting rights, which is not the case with preferred stockholders. With common stock, there's no obligation to pay dividends, while with preferred ones, whether or not dividend payments are made depends on the type of stock issued. Finally, if a company becomes profitable and wants to buy back some of the stock, it will find it cheaper to do so with preferred stock than with common stock.

Common Stock Identification

  • Common stock makes its holders part-owners of the issuing company. They have the right to know how their company is run and who runs it. The company sends them annual financial reports and sometimes minutes of the board of directors’ meetings. These stockholders can vote for a new board of directors, and their vote is proportional to the number of shares they own. Profitable companies may decide to share their profits with stockholders by paying them dividends, but they're under no obligation to do so. If the issuing company goes into liquidation, common stockholders are the last in line, after bondholders and preferred stockholders, to get their money back.

Preferred Stock Identification

  • “Preferreds,” as they're known, also offer their holders part-ownership but without the voting rights. They pay fixed dividends, usually four times a year, and always before those paid to common stockholders. The company usually decides on the dividend rate before it issues the stock — usually an adjustable rate linked to some other interest rate, for example a U.S. Treasury bond — but it's under no obligation to pay it. However, if it issues cumulative stock and at some point suspends paying dividends, it later has to pay the stockholders back in arrears. Additionally, preferred stock dividends are usually higher as a way to entice investors to buy an otherwise less attractive equity.

Buyback Option

  • A company may issue callable, or redeemable, preferred stock, which gives it the right to buy back that stock at any time and for any reason. Profitable companies sometimes do this so they don't have to pay higher dividends anymore. Another common reason to buy back preferred stock is to issue common stock when demand is high and raise more money that way.

Common Stock Advantages

  • Common stock pays less in dividends than preferred stock, and once this type of stock is sold through an initial public offering, the issuing company basically has no more obligations toward the stockholders. Because of its greater potential to grow in value, common stock is usually easier to sell.

Preferred Stock Advantages

  • Because preferreds pay regular, fixed dividends, they can be attractive to those investors looking for steady income with relatively low risk. U.S. corporations, but not individuals, that buy preferred stock are entitled to tax discounts from dividends they receive. This sometimes makes preferreds easier to sell than common stock. Finally, a company may opt for preferred stock so that it doesn’t have to change its voting structure, which may suit existing common stockholders.

Misconceptions

  • Many investors consider preferred stock a form of debt, similar to bonds. This is because preferreds, like bonds, pay a fixed amount of money at regular intervals and can be bought back and converted into common stock. However, the money raised through a sale of preferred stock is listed as equity on a company’s books and doesn't affect a company’s credit rating. This is another reason why preferred stock may be an attractive option for companies concerned about their future credit-raising potential.

References

  • Photo Credit Christine Balderas/Photodisc/Getty Images
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