Common Stock vs. Preferred Stock
There are two classes of stock that companies offer: common and preferred. These come with different financial terms and offer different rights in relation to the governance of the company. Here are some of the key differences between these two types of stock and the implications for how each type is used.
The holders of common stock can reap two main benefits from the issuing company: capital appreciation and dividends. Capital appreciation occurs when a stock's value increases over the amount initially paid for it. The stockholder makes a profit when he or she sells the stock at its current market value after capital appreciation.
Dividends, which are taxable payments, are paid to a company's shareholders from its retained or current earnings. Typically, dividends are paid out to stockholders on a quarterly basis. These payments are usually made in the form of cash, but other property or stock can also be given as dividends. Payment of dividends, however, hinges on a company's capacity to grow -- or at least maintain -- its current or retained earnings. This means that ongoing payment of dividends cannot be guaranteed.
Common stock ownership has the additional benefit of enabling its holders to vote on company issues and in the elections of the organization's leadership team. Usually, one share of common stock equates to one vote.
Preferred stock doesn't offer the same potential for profit as common stock, but it's a more stable investment vehicle because it guarantees a regular dividend that isn't directly tied to the market like the price of common stock. This type of stock guarantees dividends, which common stock does not. The price of preferred stock is tied to interest rate levels, and tends to go down if interest rates go up and to increase if interest rates fall.
The other advantage of preferred stock is that preferred stockholders get priority when it comes to the payment of dividends. In the event of a company's liquidation, preferred stockholders get paid before those who own common stock. In addition, if a company goes bankrupt, preferred stockholders enjoy priority distribution of the company's assets, while holders of common stock don't receive corporate assets unless all preferred stockholders have been compensated (bond investors take priority over both common and preferred stockholders).
Like common stock, preferred stock represents ownership in a company. However, owners of preferred stock do not get voting rights in the business.
The different types of preferred stock include:
- Participating preferred stock, which entitles holders to dividend increases if, during a given year, common stock dividends exceed those of preferred stock dividends.
- Adjustable-rate preferred stock, which is tied to Treasury bill or other rates. The dividend is augmented based on the shifts in interest rates, determined by an established formula.
- Convertible preferred stock, which has a conversion price named at its issuance so that it can be converted to a company's common stock at the set rate.
- Straight or fixed-rate perpetual stocks, which have no maturity date because the dividend rate is set for the life of the issue.
Companies that undergo multiple rounds of financing may issue multiple classes of preferred stock. In these situations, each stock class is granted its own set of rights, per its round of financing (for example, "Group I Preferred," "Group II Preferred," and so on).
Typically, preferred stock is favored by private companies, which often want to separate stockholders' economic interest in the company from the actual governance of the business. Another reason that preferred stock is primarily a tool of private companies is that stock exchanges and governing bodies tend to frown upon companies issuing preferred shares that can be publicly traded.
Issuing stock to shareholders, even in a very small corporation, is a complicated process. Consult this checklist to ensure that you don't miss any critical steps.
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