Preferred stock is a financial instrument used to help raise funds in the private market. Typically, preferred stockholders receive a priority claim over dividends and distribution of company assets in the event of liquidation. Some investors may favor the priority claim and private equity companies can use this to help attract investors.

What is Preferred Stock?

In general, preferred stock may provide some benefits compared to common stock. Holders of preferred stock have a priority claim when a company pays dividends or distributes assets. Only after payments are made to preferred stockholders does the remaining allocated capital, if any, go to the common stockholders. Additionally, if a company goes bankrupt, preferred stockholders have priority over common stockholders if any assets are available for payout. The other main difference between preferred stock shareholders and common stockholders is that preferred stock shareholders usually do not hold voting rights while common stockholders typically do have voting rights.

Preferred stock is convertible to common stock in certain scenarios. The preferred stockholder may have the option to convert preferred stock into a fixed amount of common stock or a percentage of common stock outstanding on a future date – while still maintaining key preferred rights.

Properties of Preferred Stock

There are a few key properties of preferred stock in the private market. These provisions include:

Liquidation Preference

The liquidation preference specifies the order of which investors receive a return, if any, upon a liquidation event such as a merger or acquisition. Typically, the first paid out upon a liquidation event are secured debtholders, creditors, or other company obligations. Then, preferred stockholders receive priority to the liquidated assets before common stockholders. Liquidation preferences may be participating, non-participating, or capped:

• Participating – also known as double-dip preferred stock, a participating liquidation preference favors the participating preferred investor. After receiving the liquidation preference, the investor also receives a pro-rata share of the remaining proceeds
• Non-Participating – also known as straight preferred, the preferred stock investor receives their liquidation preference at the set multiple, but does not receive a share of the remaining proceeds
• Capped Participating – often seen as an intermediate option, the preferred stock investor receives the liquidation preference and a pro-rata share of the remaining proceeds until total proceeds reach a pre-determined multiple of the original investment amount.

To learn more about liquidation preferences, check out our recent blog What is a Liquidation Preference?

Voting Rights

Some types of preferred stock include voting rights to the shareholder. Generally, common stock provides full voting rights to its holders, preferred stockholders receiving voting rights is uncommon. Even in the case of preferred stockholders receiving voting rights, they may be limited – typically only if the issuer did not pay out dividends.

Dividends

Dividends can be paid out by the issuer of the stock when – or if – capital allows; this may be monthly, quarterly, or annually but is dependent on availability of funds. However, common stockholders typically don’t receive dividends until the preferred stockholders have received their full dividend payment. If there is not sufficient capital to pay out all the preferred and common stockholders, preferred stockholders are paid dividends until the capital is fully allotted.

Redemption Rights

Redemption rights are a provision of preferred stock that allows investors to require the issuer to repurchase their shares after a specified amount of time. They were designed to help the investor by providing some liquidity, however; redemption rights are rarely exercised. Expressed as a percentage of the original investment, the redemption right can be triggered by a majority vote of investors and often, the rights cannot be exercised for a period of time – typically years. The redemption price that comes from exercising a redemption right is typically equal to the original investment plus any accrued but unpaid dividends.

Conversion Rights

A conversion right can give the issuer or the investor the ability to convert preferred stock into common stock. There are two types of conversion rights – optional and mandatory. Optional allows the investor to elect to convert their preferred shares into common shares. Mandatory conversion rights require the investor to convert their preferred shares into common shares after a specified amount of time. These mandatory rights happen automatically and are sometimes referred to as “automatic conversion”

Potential Benefits and Limitations

The priority claim over dividends and distribution of company assets typically associated with preferred stock can make it an appealing choice for investors. This priority claim also applies in the event of bankruptcy or liquidation of the issuer. Additionally, in some cases, preferred stock may allow investors to convert the preferred stock to common stock and still participate in dividends. However, like all equity, preferred stockholders are subordinate to debt and trade creditors.

Additionally, some preferred stocks may include built-in features that provide the holder with some voting or veto rights. However, this is not always the case, and the parameters can differ on each investment.

Putting it All Together

Preferred stock is a common equity structure that allows an investor to hold equity in the company and includes a dividend payment provision. Preferred stockholders are typically given preferential position when receiving dividends or a distribution of company assets upon a liquidation event. The different features of preferred stock can make it an appealing choice for many investors.

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.