The Pros and Cons of Preferred Equity Investments

March 31, 2020

The Pros and Cons of Preferred Equity Investments

Business owners that take on outside investors typically have (at least) two classes of securities: common equity and preferred equity (also called preferred shares). Common equity is typically owned by the business founders, while preferred equity is typically owned by investors. Both signify ownership in the business.

The term “preferred” represents additional privileges and rights that investors get in return for their investment (beyond owning a part of the business). In return for investing, an investor receives shares or equity that represent their ownership in the business.

The biggest difference between common equity and preferred equity is that preferred equity shareholders get paid before common equity shareholders. So in a preferred equity structure, a company pays back all net profits or cash flow to its preferred investors until they receive a return on their investment (which was previously agreed upon). After the preferred equity investors are paid, the remaining amount goes to common equity investors.

Both forms of equity represent ownership interests in a company for third party investors, but they don’t have direct recourse to the asset and are not secured (like secured debt).

Pros and Cons of Preferred Equity

Pros 

  • Potential stream of income. Preferred equity investments can generate a steady stream of income if the company issuing the preferred equity is successful.
  • Guaranteed dividend (assuming the company does not fail). Preferred investments typically guarantee a dividend of a certain percentage of the share value.
  • Flexibility. Preferred stock owners can convert some of their preferred equity into common equity, depending on the type of preference shares.
  • Liquidation preference. In the case of company liquidation, owners of preferred equity have priority over those who own common stocks.

Cons 

  • No dividend growth and income risk. Preferred stock dividends are fixed, meaning they don’t increase over time as the company grows (unlike common stock dividends). Furthermore, preferred equity dividends are not guaranteed in case the company experiences financial difficulties. It may leave the investors stuck with shares that have neither dividends nor appreciation potential.
  • Lack of voting rights. Typically, preferred equity investments don’t come with voting rights. That means preferred equity shareholders don’t play a role in a company’s decision-making process and cannot participate in the election of the company’s board of directors.
  • Interest rate sensitivity. Investors tend to make preferred equity investments for the high dividends. But since the dividends on these investments are fixed — and therefore tied to interest rates — they are sensitive to interest rate changes. So they shrink when interest rates rise.
  • Limited upside potential. Preferred equity investments’ upside potential is limited by the additional features they carry.
  • Principal risk. If a company files for bankruptcy, preferred equity investors have priority over common equity investors. But preferred shareholders can still often suffer a complete loss (just like common shareholders) if the company runs out of assets by the time preferred shareholders are due to be paid. 

Understanding Preferred Equity

If a company has to suspend its dividend for whatever reason and then resumes payments, preferred shareholders get paid before common shareholders. These shares are known as cumulative shares. If a company has several problems concerning preferred shares, they may rank them in terms of priority. The highest-ranking is known as prior and is followed by first preference, second preference, and so on. If a company is liquidated, preferred shareholders have a prior claim on its assets.

Preferred shares are regulated as equity, but in many ways, they’re hybrid assets that lie between bonds and stocks. Since preferred shareholders don’t enjoy the same guarantees as debt investors and creditors, these shares are typically rated lower than the company’s bonds, with accordingly higher yields.

Preferred shares generally trade within a few dollars of their issue price. Premium or discount trading depends on the specifics of the issue and the company’s credit-worthiness. 

Callable preferred equity shares can be purchased back by the issuer at par value — par value being the per-share value assigned by the company issuing the shares — after a set hold period. If interest rates fall and the dividend yields are not high enough to be attractive, the company may call shares. Then it can issue another series of shares with a lower yield. Certain preferred equity is convertible, which means that it can be exchanged for a given number of common shares. A few circumstances that could result in convertible preferred equity include investors being given options to convert, a board of directors voting to convert, or the shares coming with a pre-set conversion date. Whether this will be an advantage or disadvantage to the investor depends on the price of the common stock.

Before You Invest

Before you decide to start investing your money on crowdfunding platforms, be sure to understand the terms of the deal. If preferred equity is an option, make sure you understand what it entails. Some crowdfunding investors might be interested in equity options to gain some passive income and improve their personal finances. Others may want to own preferred shares because they strongly believe in the mission of a business. 

Whatever your level of experience, make sure to do your due diligence before investing in a company.


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About: Chris Lustrino

A Boston College Eagle for life, on a mission to democratize startup investing for all people at KingsCrowd, with a passion for Fintech, investing, social impact, doing well and doing good, and an avid runner, cyclist and writer.

View Chris Lustrino's articles

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