What are preferred stocks?
Preference shares or preferred stock are shares that give the shareholder additional rights. In this article, we will discuss the meaning of preferred stock: what advantages do preference shares give you?
What are preferred stocks?
Preference shares or preferred stocks are shares with additional rights. The holders of preference shares have priority in the payment of dividends. The holder of a preferred stock receives a fixed, stable dividend percentage on an annual basis. This percentage is not related to the profitability of the company. Even if the company goes bankrupt, holders of preference shares have priority. Some preferred stocks give the shareholder even more advantages.
In exchange for these extra benefits, the party who buy the preference shares often cannot sell them within a certain period.
Holders of preference shares (preferred shareholders) usually receive the right to preferential treatment regarding dividends. This means that the holder of a preference share receives dividends earlier than the holder of ordinary shares. Only when there is money left after this payment, the other shareholders may receive dividends.
In most cases, the holder of a preference share receives a fixed amount of dividend. In some cases, however, the dividend depends on an external indicator. This can be an interest rate index such as the LIBORI.
In short, preference shares offer shareholders, among other things, guaranteed dividends. Besides this, there are other possible rights the holder of preferred stock can enjoy in some cases.
Holders of preference shares may sometimes enjoy other benefits. For example, some preference shares give the holder priority in the event of a liquidation. This means that if a company goes bankrupt, the holder of a preferred stock will receive part of his money back sooner. Bondholders, however, get their money back before the holders of preference shares do.
In some cases, the holder of preference shares also receives special voting rights. They can then have a say in special cases. This may be the case when another company can be acquired or when the company wants to issue new shares.
Companies often issue preferred shares with two goals. They want to finance the company, or they want to protect the company.
The financing preferred stock are shares issued to finance the company. This type of share pays a fixed return that does not depend on the operating result. In some cases, however, the payout may be related to market interest rates. This type of share is used as an alternative to issuing a loan.
The other type is the protection preferred stock. These shares are there to protect the company against a hostile takeover. It is possible to offer these shares to the parties that are on the side of the company. This dilutes the interest of the hostile shareholder and thus reduces his or her voting rights.
There are different types of preferred stock. Below you will find the different types of preference shares and their meaning.
A company may incur a loss. In the case of cumulative preference shares, unpaid but promised dividends are recorded.
When the company returns to profitability in the future, the dividends recorded will be paid to the holders of cumulative preference shares. Holders of non-cumulative shares do not benefit from this arrangement. They only receive dividends after all the recorded dividends are paid to the holders of the preferred shares.
The majority of the preference shares are redeemable, giving the issuer the right to repurchase the shares on a specified date and for a specified price. Shareholders are often tied to the callable shares for a certain period.
When interest rates fall, the company may recall the preference shares. The company can then issue new shares at a lower fixed dividend payment.
Prior preferred stock
This is the highest ranking type of preferred share. If there is only enough money available to pay the dividend for the holders of these shares, other shareholders will be skipped.
Preference preferred stocks
Holders of preference preferred stocks receive their dividend after the holders of the prior preferred stocks, but before the holders of all the other types of shares. Sometimes a company issues preference stocks several times. When this is the case, the holders of the longest existing shares are first in line when dividends are paid out.
Convertible preferred stock
The holder of this type of preference share may at any time exchange their share for a fixed quantity of ordinary shares. This can only be done in one direction. As soon as you make use of this, you cannot exchange your shares back to preferred stocks.
An alternative form of this is the anti-dilutive convertible preferred in which the investor receives a fixed dollar amount of shares instead of a fixed number of shares.
Participating preferred stock
The holder of these shares will receive his normal dividend. In addition to the normal dividend, the holder also receives an additional dividend when certain targets are achieved within the company. This can be achieving a certain profit or achieving a certain number of sales.
Perpetual preferred stock
With this type of share, the invested capital is not repaid at a fixed time. This is the case for the vast majority of preference shares.
Preferred shares offer you the necessary advantages as an investor. With a preference share, you receive a fixed dividend percentage. Even when the profitability of the company is not going so well, you will receive this fixed amount. This gives you a nice, predictable result.
You also have a more favourable position with a preference share when the company goes bankrupt. As a shareholder, there is a good chance that you will lose your money in the event of bankruptcy. After all, creditors have priority over the owners of shares. If there is money left after all the creditors have been paid, you have priority over the normal shareholders.
What are the disadvantages of preferred stock?
Preference shares have the necessary advantages. However, there are also disadvantages associated with preferred shares. For example, a fixed dividend percentage can be disadvantageous. When the profitability of the company increases, you do not receive a higher return.
Another disadvantage of a preferred stock is that you do not have the right to vote. With a preference share, you cannot vote at the annual shareholders meeting.
Preference shares are also fairly scarce in many European countries. In America, however, you can easily buy preferred stocks.
Preferred stocks are purchased by individual investors or large organizations. Large institutions are the most common buyers of preferred shares. This is because they have many fiscal and legal advantages that do not exist for individual investors.
Because these institutional investors invest with large amounts of capital, preferred stocks can be an attractive vehicle for businesses to attract investments. For this reason, public companies like to issue large amounts of preferred shares. It is a quick and safe way to get the necessary cash.
What are institutional investors?
Institutional investors are (often huge) organizations that invest in shares on a large scale. Think of funds, 401 ks (the American pension funds) and hedge funds.
These are all large organizations that invest many billions in shares in one fell swoop. These institutions often have a big impact on the price developments of shares. Such bulk investments allow stocks to rise immediately. After all, these are large sums of money that are invested in one fell swoop in the share.
When an organization is founded, the internal shares are often divided among the founders. They become the shareholders of the company. These can be one or more people. Each shareholder usually has an equal number of shares and therefore an equal amount of control.
An organization can then choose to offer part of the shares publicly. The reasons for this vary. Shares can be issued to prevent bankruptcy. In other cases, the money raised with the IPO is used to make new investments.
A company like Tesla survived because of the shareholders until recently. Without the sale of public shares they would have never been able to establish such an innovative company. An IPO (initial public offering) is the moment when an organization sells part of its shares through the stock market.
Often an organization joins a specific stock exchange. This can be, for example, the LSE. In many cases, the share is also available at other exchanges.
The new shareholders also have a say in the organization, and they can propose changes. As the owner of shares purchased through the stock exchange, you generally have very limited control over the organization. The reason for this is simply that you do not own enough shares to be seen as a ’major shareholder’. Nevertheless, your vote at the shareholders’ meeting does count.
However, there is a risk that a large party will buy many shares. They will then have a larger voting right and will therefore be able to make changes within the company. The founders do not always agree with these changes.
When an organization engages in a ‘public sale’ of shares, they do not want certain parties to gain too much power within the company. That is why, first of all, there is often already a maximum of shares that a party can buy in one go. As a result, there will never be a huge majority with one party.
Besides this, companies ensure that two types of shares are available. This ensures that they are protected. These are the preferred stocks and the normal shares (common stock). There are different classes of shares. In most cases, you see this classification back in the letters A and B.
Often the A-class shares are not visible through the standard stock exchange. All shares you can buy at that moment are automatically all B shares. However, some companies offer both shares on the market, but you can only buy them if you are a professional investor. This is a prestigious title given to you by the SEC (Securities Exchange Commission) on Wall Street. Whether you get this title depends on your assets, papers, financial background and other specifications.
Companies often issue preferred stocks to raise money for investments. A major advantage of preference shares is that the risk of this form of capital is low. After all, when things go badly, a company does not have to pay out a dividend. When the company would have borrowed the money through a loan, they would still have to pay interest. Moreover, the buyers of this type of share often do not have voting rights, which means that the companies still retain control over their company.
Preference shares are sometimes also used to prevent a hostile takeover. More shares are then issued to dilute the percentage of the party trying to take over the company.