Preferred shares: Overview, definition, and example
What are preferred shares?
Preferred shares, also known as preferred stock, are a class of equity securities that provide shareholders with preferential treatment over common shareholders in certain aspects, such as dividend payments and claims on company assets in the event of liquidation. Preferred shareholders typically receive a fixed dividend, which is paid out before dividends are issued to common shareholders. Additionally, in the event of a company’s liquidation or bankruptcy, preferred shareholders are prioritized over common shareholders for repayment of the company’s remaining assets. However, preferred shareholders usually do not have voting rights, which distinguishes them from common shareholders.
Why are preferred shares important?
Preferred shares are important because they offer a hybrid investment that combines elements of both equity and debt. They provide a more predictable income stream than common shares due to the fixed dividend, making them attractive to income-focused investors. Preferred shares can also offer greater protection in case the company faces financial difficulties, as they give shareholders priority in asset claims and dividend payments. For companies, issuing preferred shares is a way to raise capital without diluting the voting power of common shareholders, as preferred shares typically do not carry voting rights.
Understanding preferred shares through an example
Let’s say a company, TechSolutions Inc., issues preferred shares to raise capital for expansion. Each preferred share comes with a fixed dividend rate of 6%, meaning shareholders will receive 6% of the face value of their shares as a dividend, paid quarterly. If the company faces financial difficulties, preferred shareholders are paid their dividend before any dividends are distributed to common shareholders. In the event that TechSolutions Inc. is liquidated, preferred shareholders would be paid out from the company’s remaining assets before common shareholders, but after bondholders or other creditors.
In another example, a company, GreenEnergy Ltd., issues 1,000 preferred shares at a price of $100 per share, with a fixed dividend of $8 per share annually. If the company declares a dividend, the preferred shareholders will receive their $8 per share before common shareholders receive anything. If the company performs well and the dividend is increased, preferred shareholders still receive their fixed $8 dividend, but they do not participate in the upside beyond that amount, unlike common shareholders.
An example of preferred shares clause
Here’s how a clause related to preferred shares might look in a shareholder agreement or investment document:
“The Company agrees to issue [number] of preferred shares, each with a face value of $100, providing a fixed annual dividend of 6%, payable quarterly. The dividends shall be paid before any dividends are declared for common shareholders. In the event of liquidation, preferred shareholders will have priority over common shareholders in receiving distributions, but will be subordinate to the claims of creditors.”
Conclusion
Preferred shares are an important financial instrument that offer investors the advantage of fixed dividends and priority claims on company assets, making them an attractive option for income-seeking investors. For companies, issuing preferred shares is a way to raise capital without diluting the voting rights of common shareholders. While preferred shares provide enhanced security and predictable returns, they typically do not offer the same level of upside potential or voting power as common shares. Understanding the structure and benefits of preferred shares can help both investors and companies make informed decisions about capital structure and investment strategies.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.