Should Investors Prefer Preferred Stock?
In online startup investing, both preferred stock and common stock are widely offered by companies to investors. (Preferred stock is more rare in the public market.) Therefore both retail investors and institutional investors in the private market need to understand how preferred stock works. This understanding can enable them to negotiate better key terms of preferred stocks and obtain better leverage in their investment portfolio.
Unlike common stock, preferred stock often pays investors a fixed dividend in addition to a liquidation preference. And preferred stockholders typically do not have voting rights. It’s also seen as less risky than common stock. But is preferred stock always more “preferred” as the name suggests? Not necessarily. Let’s break it down.
Dividends and Liquidation Preference
Preferred stock typically pays a fixed dividend, which equals a percentage of the stock’s par value. Dividends are usually paid quarterly or semi-annually. For example, a preferred stock that pays 8% annual dividend on a $100 par value will earn $8 annually. If the dividends are dispersed quarterly, the preferred stockholder would receive $2 each quarter per share. Dividends for preferred stock are typically higher than dividends for common stock. However, dividends are not guaranteed.
In an event of liquidation, preferred stock has a higher priority of claim than common stock. Liquidation preference for preferred stock also comes with a multiple of the initial investments. For example, preferred stockholders with a 2x liquidation preference will receive double their initial investments — before common shareholders can claim their payouts. Common stock does not receive liquidation preference.
Key Preferred Stock Terms
Cumulative vs. Non-cumulative
Cumulative preferred stock will accumulate any missed dividends by the issuing company. If there are ever times where a company does not issue dividents — such as in a liquidation event — cumulative preferred stockholders will receive all the missed dividends that would have been issued in that time period. However, non-cumulative preferred stock does not have that advantage. The issuing company is not required to pay back any missed dividends on non-cumulative preferred stocks.
Convertible vs. Non-convertible
One of the great advantages of convertible preferred stock is its ability to convert to common stock. The benefit of converting to common stock is that the payout could be higher than dividends and the multiple of liquidation preference. However, non-convertible preferred stock does not have this option.
Participating vs Non-participating
Participating preferred stock allows its shareholders to enjoy the usual benefits of dividends and liquidation preference as well as the upside of participating as common stock. Investors of such preferred stock can “double dip.” Non-participating preferred stockholders can only choose either dividends and liquidation preference or conversion to common stock (assuming the preferred stock is convertible). The total potential payout for non-participating preferred stock is therefore limited.
When is Preferred Stock Less “Preferred?”
Voting rights are important for some investors. They can grant investors a board seat, enabling them to be part of critical decisions for a company. These decisions could be hiring senior executives and approving the sale of the company. For startups, these board decisions are directly correlated to the operational success for the company, and eventually a great return on investments for investors. Therefore, many institutional investors prioritize voting rights in the private market. Having preferred stock in the term sheets will not help in this situation. Instead, common stock might be more “preferred.”
When the preferred stock is non-convertible and non-participating, stockholders will only receive dividends and liquidation preference. Such preferred stock would lose the benefit of owning equity, as the investors will not have any upside potential. If the liquidation preference is 1x, non-convertible and non-participating preferred stock acts more like debt — the dividends are like interests and the 1x liquidation preference is like principal. However, actual debt will always have payment priority over all stockholders. Furthermore, dividends are not guaranteed and could be non-cumulative, whereas interest for debt is much more secure. Unless the dividend is high enough and cumulative to compensate above compromises, preferred stock is less “preferred” than debt in this scenario.
Even when investors have convertible participating preferred stock, investors might still choose to convert their shares to common stock for a greater return. Issuers of participating preferred stock could pay a significant price at an event of liquidation. Therefore, a cap can be added to participating preferred stock. The cap is typically expressed as a multiple of the original investment.
For example, a participating preferred stock could have a 1x liquidation preference with a 2x cap. Let’s say the original investment is $100. In a liquidation event, the equivalent amount of common stock is now worth $300. Without the cap, the participating preferred stock holder would receive $400 — 1x liquidation preference at $100 and $300 common stock equivalent payout. With the 2x cap, the participating preferred stock holder would only receive $200 — 1x liquidation preference at $100 and a capped amount of common stock equivalent payout at $100. The total payout is capped at 2x the original investment. In this scenario, it makes sense for the investors to convert all of the shares to common stock for a greater payout at $300. Therefore, with the cap in place, the preferred stock payout is less “preferred” than the common stock payout.
Read the Fine Print
In summary, preferred stock offers better downside protection and is more flexible than common stock. However, investors should always know the key terms on their preferred stock — especially regarding dividend cumulation, convertibility, and levels of participation. Sometimes converting to common stock may yield a better return for investors. It’s also important to know that debt holders will always receive payment priority over stockholders. And if voting rights are important in your investment thesis, perhaps common stock is a better option. Overall, the question of whether preferred stock really is “preferred” rests with each individual investor and what they prioritize in their portfolio.
