Preferred Shares

A senior class of equity

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What are Preferred Shares?

Preferred shares (also known as preferred stock or preference shares) are securities that represent ownership in a corporation, and that have a priority claim over common shares on the company’s assets and earnings. The shares are more senior than common stock but are more junior relative to bonds in terms of claim on assets. Holders of preferred stock are also prioritized over holders of common stock in dividend payments.

Preferred Shares

Features of Preferred Shares

Preferred shares have a special combination of features that differentiate them from debt or common equity. Although the terms may vary, the following features are common:

  • Preference in assets upon liquidation: The shares provide their holders with priority over common stock holders to claim the company’s assets upon liquidation.
  • Dividend payments: The shares provide dividend payments to shareholders. The payments can be fixed or floating, based on an interest rate benchmark such as LIBOR.
  • Preference in dividends: Preferred shareholders have a priority in dividend payments over the holders of the common stock.
  • Non-voting: Generally, the shares do not assign voting rights to their holders. However, some preferred shares allow its holders to vote on extraordinary events.
  • Convertibility to common stock: Preferred shares may be converted to a predetermined number of common shares. Some preferred shares specify the date at which the shares can be converted, while others require approval from the board of directors for the conversion.
  • Callability: The shares can be repurchased by the issuer at specified dates.

Asset Priority Claim
Figure 1. Asset Priority Claim

Types of Preferred Stock

Preferred stock is a very flexible type of security. They can be:

  • Convertible preferred stock: The shares can be converted to a predetermined number of common shares.
  • Cumulative preferred stock: If an issuer of shares misses a dividend payment, the payment will be added to the next dividend payment.
  • Exchangeable preferred stock: The shares can be exchanged for some other type of security.
  • Perpetual preferred stock: There is no fixed date on which the shareholders will receive back the invested capital.

Advantages of Preferred Shares

Preferred shares offer advantages to both issuers and holders of the securities. The issuers may benefit in the following way:

  • No dilution of control: This type of financing allows issuers to avoid or defer the dilution of control, as the shares do not provide voting rights or limit these rights.
  • No obligation for dividends: The shares do not force issuers to pay dividends to shareholders. For example, if the company does not have enough funds to pay dividends, it may just defer the payment.
  • Flexibility of terms: The company’s management enjoys the flexibility to set up almost any terms for the shares.

Preferred shares can also be an attractive alternative for investors. The investors may benefit in the following way:

  • Secured position in case of the company’s liquidation: Investors with preferred stock are in a more secure position relative to common shareholders in the event of liquidation, because they have a priority in claiming the company’s assets.
  • Fixed income: These shares provide their shareholders with a fixed income in the form of dividend payments.

Related Readings

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