If you have or are contemplating investing in the stock market, you know what a common stock is. If you have any questions concerning common stock, you can look at the discussion thereof on another page in this site. In this article, we will provide the reader with some general information concerning preferred stock. Please keep in mind that this information is being provided for informational purposes only and should not be considered as legal or investment advice. Any specific questions that you have relative to preferred stocks should be addressed to your legal or investment professional.
When a corporation is created, the incorporators are required to issue common stock as holders of the common stock own the company and by executing their voting rights control the company through their election of officers and directors.
At the time that a corporation is created, the incorporators, in the certificate of incorporation, may authorize the company to issue one or more series of preferred stock. If the initial articles of incorporation do not provide for the issuance of preferred stock, the common stockholders can vote to amend the articles of incorporation, at sometime in the future, to authorize the company to do this.
Most average investors have dealt in or heard only about preferred stock that is traded on an exchange, which is purchased through broker/dealers. However, there is an investment sub-culture that utilizes preferred stock in seeking to raise venture capital for startup companies. In this latter circumstance, the preferred stock is not registered. Consequently, these shares may only be offered or sold in a transaction, which makes the shares exempt from registration such as Regulation D. However, this article is not designed to discuss this issue.
Even though the articles of incorporation of a company authorized the issuance of preferred stock, the company still has to create a document establishing the terms pursuant to which the preferred stock will be issued. This document is called a “certificate of designations, preferences and rights.” A copy of this document can usually be obtained from the corporate department of the state in which the corporation is incorporated.
What is Preferred Stock?Preferred stock is a hybrid security that combines features of common stocks and bonds. It is equity, not debt, however, and is thus riskier than bonds. Preferred stock pays a fixed dividend and in the event of bankruptcy is senior to the claims of common stock on the earnings and assets of a company. Preferred stock, like common stock, also represents an equity ownership in a company. Equity is defined as capital invested in a company by its owners; debt is capital lent to the corporation, which must be repaid.
Although preferred stock is classified as equity, preferred stockholders do not have an ownership interest in the company. The failure of a company to pay dividends to preferred stockholders does not result in bankruptcy as it would with the default of interest on bonds. Instead, the company does not pay common stockholders and dividends until the preferred stockholders are paid their dividends.
Are There Multiple Classes of Preferred Stock?Most companies have only one class of common stock, but it is quite common to see companies with more than one series of preferred stock. Each class of preferred stock has different features. It is for this reason that, as an investor, you need to make sure that you understand what the exact terms of your series of preferred stock are.
What are Cumulative Dividends?Most preferred stock carries a cumulative dividend feature, which is a provision requiring a company to pay any preferred dividends that have not been paid in full before the company can pay dividends to its common stockholders. Also, one series of preferred stock may have dividend preference over another series of preferred stock. A preferred issue that does not have a cumulative feature is called a noncumulative preferred stock. Their dividends do not accumulate if they are not paid.
Does Preferred Stock Have Convertible Feature?Some preferred stock issues have a convertible feature that allows holders of preferred stock to exchange their preferred stock for common shares. The conditions of the conversion are set when the preferred stock is first issued. The terms include the conversion ratio, which is the number of common shares the preferred stockholder will get for each preferred share is exchanged, and the conversion price of the common stock.
Some of the factors that must be considered in the decision to exercise the conversion option depend on:
A preferred stock issue with a call provision entitles the issuing company to repurchase the stock at its option from outstanding preferred stockholders. The call price is generally more than the preferred stock’s par value. The call provision is advantageous to the issuing company and not to the holder of the preferred stock. When market rates of interest decline significantly below the dividend rate of the preferred issue, companies are more likely to exercise the call provision by retiring the issue and replacing it with a new preferred stock issued with a lower dividend rate. When a preferred issue is called, the savings to the issuing company represent a loss of income to the preferred stockholders.
Most of the issues that we have handled for investors over the years usually relate to matters concerning the issue of suitability. This relates to the suitability of the investment at the time of its recommendation to and its purchase by you; and, under some circumstances whether or not it was suitable for you to retain the investment in your account However, this is not something that you will not be able to establish on your own. It will require a skilled professional to assist you in this regard.
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