Takeaways
- Preferred shares are equity securities issued by companies to raise capital.
- Preferred shares have equity and debt security features that entice investors.
- Startups issue preferred shares to attract accredited and institutional investors.
- Fixed-income investors enjoy preferred shares for high fixed-income payments.
- Preferred shares can have convertibility features that exchange preferred shares for common stocks.
What Is Preferred Stock?
Preferred stock is a type of equity security that gives shareholders a higher claim on a company’s assets and earnings than common stockholders. As a result, preferred shareholders are paid dividends before common shareholders, and in the event of liquidation, they are first in line to receive payouts after creditors.
Preferred stock is often referred to as a “hybrid” security because it shares characteristics of both stocks and bonds. Like common stock, it represents ownership in a company, but like bonds, it typically provides fixed dividends and limited, if any, voting rights.
Preferred stock appeals to investors looking for regular income with less risk than common stock but higher returns than bonds.
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How Preferred Stock Works
Preferred stockholders enjoy several unique privileges. Most preferred shares pay a fixed dividend, which is specified when the shares are issued. These dividends are often a percentage of the stock’s par value (a set value determined by the company).
For example, if a preferred stock has a par value of $100 and pays a 6% dividend, shareholders will receive $6 annually per share. Preferred stock dividends are typically paid quarterly, offering consistent income to investors.
While preferred shareholders generally do not have voting rights in corporate matters, they benefit from greater financial security than common stockholders.[1] However, the value of preferred stock may not appreciate as much as common stock over time.
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7 Types of Preferred Stock
Before investing in preferred stock, there are many types to consider. Some companies offer a range of preferred stock. Here are seven categories to consider:
1. Prior Preferred Stock
This type of preferred stock holds the highest claim on a company’s earnings and assets.
If the company can only afford to pay dividends to one class of preferred stock, prior preferred shareholders are paid first.
2. Preference Preferred Stock
Preference preferred stockholders receive dividends before common stockholders, but their claim is lower than prior preferred stockholders.
This type of preferred stock is more common than prior preferred stock.
3. Perpetual Preferred Stock
Perpetual preferred stock has no maturity date. These shares remain outstanding indefinitely unless the company decides to redeem them.
Perpetual preferred stockholders enjoy a steady income stream for as long as they hold the shares.
4. Convertible Preferred Stock
Convertible preferred stock allows shareholders to convert their preferred shares into a predetermined number of common shares.
This convertibility feature lets investors participate in the company’s potential growth while also enjoying the benefits of preferred dividends.
5. Cumulative Preferred Stock
Cumulative preferred stock ensures that any missed dividend payments are added to future payouts.
For example, if a company skips a dividend payment due to financial difficulties, it must pay the arrears before paying dividends to common shareholders.
6. Noncumulative Preferred Stock
Unlike cumulative preferred stock, noncumulative shares do not allow unpaid dividends to accumulate.
With noncumulative shares, if a dividend payment is unpaid, the shareholder has no claim to those unpaid dividends in the future.
7. Participating Preferred Stock
Participating preferred stock offers additional benefits beyond fixed dividends. Shareholders can receive extra dividends if the company achieves specific profit levels.
In some cases, participating preferred stockholders may also share in the company’s liquidation proceeds alongside common shareholders.
Pros of Preferred Stock
- Priority Payment of Dividends: Preferred shareholders receive dividends before common stockholders, ensuring a more secure claim to a steady income stream. (Read more about how dividends work).
- Higher Yield: Preferred stock typically offers higher dividend yields than common stock or bonds. (Read more about the different types of bonds).
- Reduced Volatility: Preferred stock prices are less volatile than common stock, making it a safer option for income-focused investors. (Read more about how to earn passive income).
- Cumulative Feature: Some preferred shares allow missed dividends to be paid later, protecting investor income. (Read more about the fixed income investing).
- Lower Tax Rate: Dividends from preferred stock are taxable income. However, the tax rate may be lower if the dividends are qualified.[2] (Read more about the Form 1099-DIV).
Cons of Preferred Stock
- Limited Gains: Preferred stock generally does not appreciate in value as much as common stock, limiting potential capital gains. (Read more about higher-yielding investments like Bitcoin and cryptocurrencies).
- No Voting Rights: Preferred shareholders usually have no say in corporate decisions. (Read more about how a board of directors works).
- Dividends Are Not Guaranteed: Companies can skip preferred dividends if they face financial difficulties, especially with noncumulative preferred stock. (Read more about C Corporations).
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When Do Companies Issue Preferred Stock?
Companies issue preferred stock for a variety of reasons. It is often used as an alternative to debt because it does not require principal repayment. Preferred stock allows companies to raise capital without diluting common shareholders’ voting power.
For startups or financially constrained businesses, preferred stock can attract investors by offering steady dividends, more rights, and greater financial security than common stock. In some cases, companies issue preferred shares as part of a restructuring effort to strengthen their balance sheets.
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Preferred Stock vs. Common Stock
While preferred and common stock represent ownership in a company, they differ significantly. Here’s a look at the major differences:
| Feature | Preferred Stock | Common Stock |
|---|---|---|
| Dividends | Fixed and paid first | Variable and paid after preferred stock |
| Voting Rights | Generally, no voting rights | Full voting rights |
| Priority in Liquidation | Higher priority | Lower priority |
| Potential for Growth | Limited price appreciation | Higher growth potential |
| Risk | Lower risk, steady income | Higher risk, greater volatility |
| Convertible | May be able to convert to common | Unable to convert to preferred |
Preferred stock is ideal for income-focused investors seeking stable returns with less risk, while common stock appeals to those looking for significant capital gains and voting rights.
Smart Summary
Preferred stock is an equity security that gives shareholders ownership of the company. It is a unique product in equity investing because it offers a blend of features from stocks and bonds. With fixed dividends, priority over common shareholders, and reduced risk, preferred stock provides steady income for investors. Owning preferred stocks can diversify a well-balanced portfolio.
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(1) US Securities and Exchange Commission. Stocks. Last Accessed January 21, 2025.
(2) US Securities and Exchange Commission. Topic no. 404, Dividends. Last Accessed January 21, 2025.
