Preferred shareholders

What Are Preferred Shareholders?

Preferred shareholders are individuals or entities who own preferred stock, a class of equity that grants them certain preferential rights over common shareholders. These preferences typically include a higher claim on a company's assets and earnings, particularly concerning the payment of dividends and in the event of liquidation or bankruptcy. Preferred stock is often considered a hybrid security within corporate finance, blending characteristics of both common stock and fixed income investments. While preferred shareholders generally receive priority in dividend payments and asset distribution during liquidation, they typically do not possess voting rights in corporate governance, unlike common shareholders.⁵⁰

History and Origin

The concept of preferred stock emerged in the mid-19th century in the United States, with the Pennsylvania Railroad Company often cited as one of the first to issue such shares. These early issuances were designed to provide investors with a more secure investment vehicle than common equity, offering a higher dividend payout and a priority claim on company assets in the event of insolvency.⁴⁹ Preferred shares became increasingly popular in the early 20th century, particularly among large public utilities and transportation companies seeking to raise capital structure. By the 1920s, preferred stock had become a widely accepted investment.⁴⁸ More recently, preferred stock played a significant role during the 2008 financial crisis, as banks and other financial institutions utilized these instruments to meet capital requirements and raise funds. For example, during the crisis, Berkshire Hathaway made a notable investment in Bank of America through preferred shares, illustrating their strategic importance in times of market stress.

Key Takeaways

• Preferred shareholders receive preferential treatment over common shareholders regarding dividend payments and asset claims in liquidation.⁴⁷
• Dividends for preferred shareholders are often fixed and must typically be paid before any dividends are distributed to common shareholders.⁴⁶
• In a company's liquidation, preferred shareholders have a higher claim on assets than common shareholders but are subordinate to bondholders and other creditors.⁴⁵
• Preferred shareholders generally do not have voting rights, which distinguishes them from common shareholders who typically do.⁴⁴
• Preferred stock combines features of both debt and equity, offering predictable income streams while representing ownership in a company.⁴³

Formula and Calculation

The annual dividend payment for preferred shareholders is typically calculated based on a fixed percentage of the stock's par value.⁴²

The formula for calculating the annual preferred dividend per share is:

$\text{Annual Preferred Dividend Per Share} = \text{Par Value} \times \text{Dividend Rate}$

For example, if a preferred stock has a par value of $100 and a dividend rate of 5%, the annual dividend per share would be ( $100 \times 0.05 = $5 ). If dividends are paid quarterly, this amount would then be divided by four to determine the quarterly payment.⁴¹ This fixed payment contrasts with common stock, whose dividends can vary based on company profitability.⁴⁰

Interpreting the Preferred Shareholders' Position

Understanding the position of preferred shareholders involves recognizing their unique balance of advantages and limitations within a company's capital structure. Their "preferred" status primarily relates to the order of payments. This priority means that if a company declares dividends, preferred shareholders must receive their agreed-upon amount before any payments are made to common shareholders. Similarly, in the event of a company's financial distress or liquidation, preferred shareholders are paid out from the remaining assets before common shareholders. This preferential treatment offers a degree of income stability and capital protection.³⁹ However, this stability often comes at the cost of potential capital appreciation typically enjoyed by common stock and usually means no voting rights.³⁸

Hypothetical Example

Imagine "GreenTech Innovations Inc." issues 1,000,000 shares of preferred stock with a par value of $50 per share and a fixed annual dividend rate of 6%.

1. Annual Preferred Dividend per share: ( $50 \times 0.06 = $3.00 )
2. Total Annual Preferred Dividends: ( 1,000,000 \text{ shares} \times $3.00/\text{share} = $3,000,000 )

Now, let's say GreenTech Innovations Inc. has a challenging year and only manages to generate $2,000,000 in distributable earnings. Because preferred shareholders have priority, the entire $2,000,000 would go to the preferred shareholders. The remaining $1,000,000 in preferred dividends would be considered "arrears" if the preferred stock is cumulative dividends and would need to be paid in future periods before common shareholders receive any dividends. If the company were to be liquidated, and after all creditors were paid, $70,000,000 remained, preferred shareholders would receive their $50,000,000 (1,000,000 shares x $50 par value) before common shareholders receive any portion of the remaining $20,000,000. This scenario highlights the preferential claim of preferred shareholders on both earnings and assets.³⁶, ³⁷

Practical Applications

Preferred stock, and by extension the role of preferred shareholders, finds several practical applications in the financial world:

• Corporate Financing: Companies, particularly those in the financial sector like banks and utilities, issue preferred stock to raise capital. This allows them to secure financing without diluting the voting control of existing common stock holders.³⁴, ³⁵ The structure allows flexibility, as suspending preferred dividends does not constitute a default in the same way missing bond interest payments would.³³
• Income Investing: For investors seeking a steady stream of income, preferred shares are attractive due to their typically fixed and higher yield compared to common stock.³² This makes them appealing to investors focused on stable cash flows, often viewed as a hybrid between equity and fixed income securities.³¹
• Balance Sheet Management: Issuing preferred stock can help a company manage its capital structure by potentially lowering its debt-to-equity ratio, which can be favorable for credit ratings.³⁰
• Regulatory Capital: For financial institutions, preferred stock often counts towards regulatory capital requirements, making it a critical tool for maintaining financial stability and compliance.²⁹ The SEC's Financial Reporting Manual outlines specific accounting and disclosure requirements for preferred stock, underscoring its importance in regulatory frameworks.²⁷, ²⁸

Limitations and Criticisms

Despite their advantages, preferred shareholders face certain limitations and criticisms. A primary drawback is the typical absence of voting rights, meaning preferred shareholders generally have no say in major corporate decisions, such as electing the board of directors or approving significant transactions.²⁶ This can be a significant concern for investors who desire influence over a company's direction.

Another limitation is the limited potential for capital appreciation. Unlike common stock, which can see substantial price increases as a company grows, the market price of preferred stock tends to be less volatile and offers less upside potential.²⁴, ²⁵ Their fixed dividends, while stable, may become less attractive in an environment of rising interest rates, as the fixed payments do not keep pace with increasing market yields.²³

Furthermore, many preferred stocks feature a "callable preferred stock" provision, allowing the issuing company to repurchase the shares at a predetermined price after a certain date. This feature can limit an investor's long-term gains if the company calls back the stock when interest rates are low or its market value begins to rise.²² During periods of financial distress, while preferred shareholders have priority over common shareholders, they are still subordinate to all creditors and bondholders, meaning there's a risk of significant loss in the event of severe financial turmoil. Historical data shows that preferred stocks can experience substantial losses during market downturns, similar to equities, especially those heavily concentrated in the financial sector.²⁰, ²¹

Preferred Shareholders vs. Common Shareholders

The distinction between preferred shareholders and common shareholders lies primarily in their rights, claims, and potential returns within a company's equity structure.

The fundamental confusion often arises because both represent ownership in a company. However, preferred shareholders typically prioritize income and capital preservation, whereas common shareholders seek greater growth potential and influence through voting.⁷

FAQs

Are preferred shareholders considered owners of a company?

Yes, preferred shareholders are considered owners of a company, as preferred stock represents a class of equity ownership. However, their ownership rights differ from those of common shareholders, particularly regarding voting power and their claim hierarchy.⁶

What happens if a company misses a preferred dividend payment?

If a company misses a preferred dividend payment, it is not considered a default, unlike missing a bond interest payment. However, if the preferred stock is cumulative dividends, the missed payments accumulate and must be paid to preferred shareholders before any dividends can be distributed to common shareholders in the future. If it's non-cumulative, the missed dividend is typically lost.⁴, ⁵

Can preferred stock be converted into common stock?

Some types of preferred stock, known as "convertible preferred stock," can be converted into a predetermined number of common stock shares at the shareholder's option. This feature can offer preferred shareholders the ability to participate in the upside potential of common stock if the company performs well, though it may lead to dilution for existing common shareholders.³

Do preferred shares have a maturity date?

Most preferred shares are perpetual, meaning they do not have a fixed maturity date. However, some preferred shares may be "callable preferred stock," which means the issuing company has the right to repurchase them at a specified price after a certain date. Additionally, some preferred shares may have mandatory redemption features.¹, ²