Preferred stock: Overview, definition, and example
What is preferred stock?
Preferred stock is a class of stock in a corporation that has preferential rights over common stock in certain situations, such as in the payment of dividends and in the event of liquidation. Preferred stockholders are typically paid dividends before common stockholders and may have a fixed dividend rate. In addition, preferred stockholders often have limited or no voting rights in the corporation. The primary advantage of preferred stock is its stability and priority in receiving dividends, making it a popular choice for investors seeking steady income.
For example, a company might issue preferred stock with a dividend rate of 5%, meaning that preferred stockholders are entitled to receive their 5% dividend before the company pays any dividends to common stockholders.
Why is preferred stock important?
Preferred stock is important because it offers a balance between the potential high returns of common stock and the fixed income characteristics of bonds. Preferred stockholders typically enjoy the security of receiving regular dividend payments and have priority over common stockholders if the company faces financial difficulties or liquidation. Preferred stock is also attractive to companies because it allows them to raise capital without diluting control, as preferred stockholders usually do not have voting rights. Additionally, preferred stock can be structured in different ways, such as convertible or callable, offering flexibility for both investors and companies.
Understanding preferred stock through an example
Let’s say a corporation issues 1,000 shares of preferred stock with a dividend rate of 6%. If the company generates enough profit, it will pay the preferred stockholders a fixed dividend of 6% per year, calculated on the value of the preferred stock. The company pays these dividends before any dividends are paid to common stockholders. In the event that the company liquidates, preferred stockholders will have priority over common stockholders in receiving a portion of the company’s assets.
In another example, a company might issue preferred stock that is convertible into common stock at a later date. This gives preferred stockholders the potential to benefit from an increase in the company’s stock price, while still receiving the benefits of preferred stock (such as priority dividends) in the meantime.
An example of a preferred stock clause
Here’s how a preferred stock clause might appear in a shareholder agreement:
“The holders of the Preferred Stock shall be entitled to receive dividends at a rate of 5% per annum, payable quarterly. Dividends shall be paid in preference to any dividends declared on the Common Stock. In the event of liquidation or winding up of the Corporation, the holders of the Preferred Stock shall be entitled to receive, before any distribution to Common Stockholders, an amount equal to the liquidation preference of the Preferred Stock, plus any unpaid dividends.”
Conclusion
Preferred stock offers investors a combination of income stability and priority over common stockholders in the event of a company’s liquidation. While it does not typically carry voting rights, preferred stock provides the benefit of regular dividend payments and a higher level of financial security compared to common stock. For companies, issuing preferred stock can raise capital without giving up control, making it an attractive financial instrument for both investors and corporations.
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.