By J. Andrew Lipscomb
There are two classic sources of capital for a business: debt and equity. Straight debt securities generally have low levels of risk for an investor, since payment of both interest and principal are enforceable legal obligations. The reduced risk of this strategy, though, results in a reduced rate of return. At the other extreme, common equity produces higher yields at the expense of more risk: payments are not received unless the directors declare a dividend or a buyback, and creditors can sometimes block these actions.
But these are not the only forms that an investment in a company may take. An alternative option for investors is preferred stock, which is designed to have a stable, though not guaranteed, income and priority like that of debt, while retaining the flexibility offered by equity financing.
The earliest uses of preferred stock were by companies building railroads and canals, first in England and then in the United States. These companies needed more capital than could be raised as ordinary equity, but their ability to borrow was limited by the custom of the day in which each loan required a physically separate piece of collateral. (Separating a railroad line into segments would yield nothing of value.) Thus, the concept of preferred stock, which conveyed some but not all of the rights of debt, was created.
Specifically, preferred stock shares with debt the concept of a predictable return paid periodically, as well as a right to repayment ahead of the common equity. The par value of a preferred stock is generally the amount of its liquidation preference, and the annual dividend is usually stated as a percentage of that figure. However, preferred stockholders cannot actually enforce payment of their return, and they stand lower than creditors in the priority of repayment.
The exact bundle of rights held by preferred stockholders varies from one issue to another, and there may even be distinctions among different classes of preferred stock from a single company. In particular, the following characteristics may vary:
- Cumulative v. non-cumulative. If the preferred dividend is not paid on a cumulative preferred stock, the amount must be made up before any dividends may be paid to the common stock. With non-cumulative preferred stock, a missed dividend is lost permanently.
- Fixed-rate v. floating-rate. While the dividend on preferred stock is usually a fixed amount, it may be variable, based on a market index or on a performance measurement.
- Participating v. non-participating. In most cases, the dividend is the only return on a preferred stock; if dividends above that amount are declared, they go to the common shareholders. Participating preferred stock, on the other hand, receives its preferred return and then a percentage of amounts beyond that.
- Conversion/redemption features. Some preferred stocks are redeemable for a certain percentage of their par value, or they may be convertible into another class of security (usually the issuer’s common stock). The option to convert/redeem may be in the hands of both parties or of only one. (If the issuer has the option to initiate a conversion or redemption, the term “mandatory convertible” or “mandatory redeemable” is used.)
- Voting rights. Preferred stock is usually nonvoting, but may be given voting rights either in general or only when dividends are in arrears.
Also note that the business issuing preferred equity need not be a corporation. A partnership or LLC interest can be given the same kind of rights that preferred stock has in a corporation, by placing the appropriate terms in the partnership agreement or the LLC’s operating agreement. On the other hand, S corporations are under a “one-class-of-stock” rule; issuing preferred stock would result in the loss of Subchapter S status.
In general, preferred stock in a corporation is taxed in the same way as common stock, including the double taxation of dividends. Therefore, corporations receive better after-tax returns from preferred stock than for individuals do, since corporations are allowed to deduct from their income most of their dividends received. Similarly, preferred interests in partnerships and LLCs usually pass through an amount of income based on the preferred return.
Preferred equity can also be combined with other forms of investment in a transaction. One of our current transactions involves a combination of a redeemable preferred equity portion, to provide a baseline return with return of capital coming in the early years, along with common equity to give (1) upside after the return of capital is completed and (2) a share of the voting rights that does not change over the course of the transaction. In this and other scenarios, preferred equity is one of several tools used to put together the bundle of rights and returns that yields a transaction acceptable to both sides.
By J. Andrew Lipscomb