What Are Preferred Stockholders?
Preferred stockholders are individuals or entities who own preferred stock, a class of equity in a corporation that carries certain privileges over common stock. These privileges primarily relate to the distribution of dividends and the priority of claims in the event of liquidation. This makes preferred stock a key component within corporate finance and a distinct type of investment. Preferred stockholders typically receive fixed dividend payments before common stockholders are paid, and they hold a senior claim on the company's assets if the business undergoes bankruptcy or dissolution.
History and Origin
The concept of preferred shares, and by extension preferred stockholders, evolved as companies sought alternative ways to raise capital beyond traditional common stock or debt. Early forms of preferred stock emerged in the 19th century in the United States, providing a financing tool that offered investors a more stable income stream compared to common equities, while still being subordinate to bondholders. Over time, the specific rights and features of preferred stock became more defined, often varying based on the issuing company and regulatory environment. For instance, the Securities and Exchange Commission (SEC) identifies preferred stock as a type of equity with distinct voting and economic rights, often issued to outside investors, contrasting with common stock more commonly issued to founders.5 This historical development solidified the role of preferred stockholders within a company's capital structure, bridging the gap between pure equity and pure debt.
Key Takeaways
- Preferred stockholders have priority over common stockholders for dividend payments and asset distribution in liquidation.
- Preferred shares often come with a fixed dividend rate, making them attractive to income-focused investors.
- Unlike common stockholders, preferred stockholders generally do not possess voting rights in corporate matters.
- Preferred stock is considered a hybrid security, exhibiting characteristics of both stocks and bonds.
- Companies may issue preferred stock to raise capital without diluting the voting power of existing common shareholders.
Formula and Calculation
The value of a preferred stock, from the perspective of a potential preferred stockholder, is often calculated using a perpetuity formula since many preferred stocks pay a fixed dividend indefinitely. The formula to estimate the present value of a preferred stock is:
Where:
- (P_0) = Current price of the preferred stock
- (D_p) = Annual preferred dividend per share (often a fixed dividend)
- (r) = Required return on investment or discount rate (reflecting market interest rates and risk)
This formula highlights the inverse relationship between the preferred stock's value and the required rate of return, much like a bond's price and its yield.
Interpreting the Preferred Stock
Preferred stockholders hold a unique position, reflecting a blend of ownership and creditor characteristics. The designation "preferred" indicates their higher claim to dividends and assets compared to common stockholders. This priority means that if a company faces financial distress or decides to halt dividend payments, preferred stockholders must be paid any due dividends (especially if cumulative preferred stock is held) before common stockholders receive anything. The fixed nature of many preferred stock dividends provides a more predictable income stream, similar to fixed income securities. However, this preference often comes at the cost of voting rights, which are typically reserved for common shareholders. The characteristics of preferred shares are crucial for understanding their role in a company's overall capital structure.
Hypothetical Example
Consider XYZ Corp. which has both common stock and preferred stock. The preferred stock has a par value of $100 and pays an annual dividend of 5%. This means each preferred share pays $5 per year ($100 * 0.05). If XYZ Corp. declares dividends, the preferred stockholders will receive their $5 per share before any dividends are distributed to common stockholders.
Now, imagine XYZ Corp. faces financial difficulties and must liquidate. After all creditors (like bondholders) are paid, the preferred stockholders would be next in line to receive proceeds from the sale of assets, up to their par value, before common stockholders receive any remaining funds. This demonstrates the "preferred" status in both dividend distribution and liquidation scenarios.
Practical Applications
Preferred stockholders are found in a variety of financial contexts, particularly in large corporations seeking to optimize their capital structure and attract specific types of investors. Companies issue preferred shares to raise capital without diluting the voting power of existing common shareholders. This is particularly appealing for mature companies that want to maintain control while raising funds. Preferred stock is also often issued by financial institutions like banks and insurance companies, as it can count towards regulatory capital requirements.4 For investors, preferred shares offer a balance of income and relatively lower volatility compared to common stocks, especially in a stable stock market environment. They can be attractive to income-oriented investors or those seeking steady cash flow. For example, during periods of declining interest rates, existing preferred stocks with higher fixed dividends can become more valuable.3 However, preferred stock often includes "call" features, allowing the issuer to redeem the shares, typically at par value, often when interest rates fall, allowing the company to reissue at a lower dividend rate.2
Limitations and Criticisms
While preferred stock offers advantages to both issuers and investors, it also carries limitations. For preferred stockholders, the primary drawback is the typical absence of voting rights, meaning they have little to no say in the company's operational decisions or strategic direction, unlike common stockholders. Another limitation is the finite upside potential; their fixed dividend payments mean they do not participate in the significant capital appreciation that common shares might experience if the company's profitability or market capitalization surges.
Furthermore, preferred stock dividends are not legally binding obligations in the same way that bond interest payments are; a company can generally suspend preferred dividends without triggering a default, although such an action would severely damage its reputation and ability to raise future capital. The legal treatment of preferred stock, particularly for tax purposes, can also be complex and vary depending on specific provisions.1 This hybrid nature means preferred stockholders face higher risks than bondholders in the event of bankruptcy, as their claims are subordinate to all creditors.
Preferred Stockholders vs. Common Stockholders
The primary distinction between preferred stockholders and common stockholders lies in their rights and privileges within a corporation.
| Feature | Preferred Stockholders | Common Stockholders |
|---|---|---|
| Dividend Priority | Receive fixed dividends before common stockholders. | Receive dividends only after preferred stockholders are paid; dividends often fluctuate. |
| Liquidation Claim | Senior claim on assets after creditors, before common stockholders. | Last in line for asset claims after all other obligations. |
| Voting Rights | Generally do not have voting rights. | Typically have voting rights on corporate matters. |
| Upside Potential | Limited to fixed dividend payments and par value. | Unlimited upside potential through share price appreciation and variable dividends. |
| Risk Profile | Lower risk than common stock due to payment priority. | Higher risk than preferred stock but with greater reward potential. |
While preferred stockholders prioritize income stability and asset protection, common stockholders prioritize capital appreciation and corporate control through voting rights.
FAQs
Do preferred stockholders have voting rights?
No, generally, preferred stockholders do not have voting rights in corporate governance matters, which is a key difference from common stockholders. Their influence is primarily through their preferential financial claims rather than direct input on company decisions.
Are preferred stock dividends guaranteed?
Preferred stock dividends are not guaranteed in the same way bond interest payments are. While companies prioritize paying preferred stockholders before common stockholders, a company can technically suspend preferred dividend payments without defaulting. However, for cumulative preferred stock, any missed dividends must be paid to preferred stockholders before common stockholders can receive future dividends.
What happens to preferred stockholders in a bankruptcy?
In the event of a company's bankruptcy or liquidation, preferred stockholders have a senior claim on the company's assets compared to common stockholders. This means they will be paid out from the remaining assets after all creditors (like bondholders) have been satisfied, but before common stockholders receive anything.
Can preferred stock be converted into common stock?
Yes, some types of preferred stock are "convertible preferred stock," which gives the preferred stockholder the option to convert their shares into a predetermined number of common stock shares. This feature allows preferred stockholders to participate in the company's growth if its common stock performs well.