What Is Preferred Stock?

A stock, also called equity, is a security that represents the holder’s ownership of a portion of the capital of the issuing company. Stocks entitle their owners to a share of the company’s assets and profits in proportion to the number of shares they own.

Stocks are bought and sold mainly on stock exchanges and form the foundation of many individual investors’ portfolios. Stock trading is subject to government regulations designed to protect investors from fraud.

Companies issue stock to raise capital for their production and business activities. In return, stockholders (shareholders) can claim a share of the company’s assets and earnings.

Shareholders are considered owners of the issuing company, in proportion to the number of shares they hold relative to the shares outstanding. If a company has 1,000 shares outstanding and someone owns 100 of them, they own and can claim 10% of the company’s assets and earnings.

Even so, the company’s assets are legally separate from those of its shareholders, which limits the liability of both. If the company goes bankrupt, a judge may order all of the company’s assets sold, but a shareholder’s personal assets are not at risk.

A court cannot force shareholders to sell their shares, even though the shares may have fallen in value. Likewise, if a major shareholder goes bankrupt, they cannot sell the company’s assets to pay their creditors.

Not all shareholders have the same rights. In fact, there are 2 types of stock: common stock and preferred stock. Their names already hint at how the rights and benefits of holding each differ. So:

What Is Preferred Stock?

Preferred stock (preferred stock) is a type of stock whose holders are entitled to dividends or to a distribution of assets (a priority claim on capital) ahead of holders of common stock.

Priority claim on capital is also the most important feature of preferred stock. Under bankruptcy law, if a company goes bankrupt, it must liquidate as many of its assets as possible and use all of its money to pay the parties concerned in the following order of priority:

• Repay all debts to the parties concerned (banks, bondholders, suppliers…).
• Repay the capital contributed by preferred shareholders.
• Repay the capital contributed by common shareholders.

So preferred shareholders have a priority claim on capital over common shareholders if the company goes bankrupt. If the company’s money is not enough to meet all these obligations, common shareholders may lose part or all of their capital, while preferred shareholders may have been repaid in full.

Despite these advantages, preferred shareholders are subject to certain restrictions so that their rights do not overshadow those of common shareholders. Specifically, Article 117 of Vietnam’s Law on Enterprises 2020 provides that holders of dividend preference shares have no right to vote, attend the General Meeting of Shareholders, or nominate members of the Board of Directors and the Supervisory Board, except as provided in Clause 6, Article 148 of the Law on Enterprises 2020.

Advantages of Preferred Stock

Preferred stock gives its holders certain rights that differ from those of common shareholders. Specifically, preferred stock usually pays higher dividends and has a higher claim on assets if the company is liquidated.

In some cases, preferred stock is also callable, meaning the issuer has the right to buy back the shares at a price and date set in advance, as stated in the prospectus. In many ways, preferred stock behaves like a bond, which is why it is sometimes called a hybrid security.

Types of Preferred Stock

Preferred stock is usually divided into the following types:

Dividend Preference Shares

This is the most common type of preferred stock. Holders always receive a fixed annual dividend, whether the company makes a profit or a loss, as specified when the shares are issued. This makes preferred stock less risky than common stock, with more stable cash flow and greater capital safety.

So preferred stock has features of both a stock (representing ownership of part of the company’s capital) and a bond (a fixed dividend, like a coupon).

Because preferred stock is low risk, its expected return is naturally lower than that of common stock. If the company makes large profits, it can raise the dividend on common stock while the preferred dividend stays the same.

However, this stock does not carry voting rights as common stock does. Companies therefore issue and offer dividend preference shares to raise capital without diluting existing shareholders’ voting rights, so they do not lose control of the company.

Companies aim to offer preferred stock to purely financial investors (who are focused only on returns and may not know much about the company’s line of business).

Some dividend preference shares allow investors to convert them into common stock at a pre-agreed ratio.

Voting Preference Shares

This is a type of common share whose holder has more votes than other common shares; the number of votes per voting preference share is set by the company’s charter. This lets preferred shareholders take a more active part in the company’s affairs.

However, this type of preferred stock lasts a maximum of 3 years, after which it converts into common stock. Typically, founding shareholders hold this type of stock so they can take part in early funding rounds without diluting their voting share; you can see an example in Facebook’s IPO in 2012.

In addition, voting preference shares cannot be transferred to other shareholders. They also carry the basic rights of common stock, such as the right to dividends.

Redeemable Preference Shares

This preferred stock is like a common share with a put option attached. Holders have the right to sell the shares back to the company to recover their capital (usually at par value) after a certain period, which protects investors if the company performs poorly and the share price falls.

Holders of these shares may also receive dividends, like common stock, but they have no voting rights and are subject to transfer restrictions.

How Does Preferred Stock Differ from Bonds?

Preferred stock is often compared with bonds because both can give their holders regular cash payments. However, since stocks and bonds differ in many ways, bonds also differ from preferred stock.

In terms of similarities, both are usually issued at a par value (face value). This value is used to calculate future dividend payments and has nothing to do with the security’s market price.

Companies can then pay dividends in much the same way that bonds make regular coupon payments. Although the mechanisms differ, the end result is that holders receive cash.

Even so, preferred stock and bonds have their differences. Dividend payments on preferred stock are not fixed and can be changed or suspended, whereas bonds usually mature after a set period. So in theory, preferred stock has no “end date”, while bonds do.

There are also considerations about the order of claims if a company goes bankrupt and is liquidated. In most cases, bondholders have priority and receive the proceeds from the liquidated assets first. Preferred shareholders are compensated only after that, if any assets remain. Common shareholders come last and usually receive little or nothing when a company goes bankrupt.

In some cases, investors need to assess the condition of the company whose shares, and preferred shares in particular, they hold in order to make sound investment decisions. In practice, a company falling into financial distress is a warning sign that investors should act on their preferred shares to protect their interests.

How Do You Buy and Sell Preferred Stock?

There are 2 ways for investors to buy preferred stock: from the issuing company or through a securities company.

Unlike common stock, not every company issues preferred stock, and in Vietnam it does not trade on the centralized exchange. Preferred stock is issued according to each company’s own plans and programs, and the company then notifies the securities depository.

If an investor wants to buy preferred stock from the issuing company, the transaction takes place between the company and the investor. The investor needs to register their subscription rights and follow the issuer’s instructions.

Alternatively, the issuing company may not handle sales itself but appoint a third party, usually a securities company, to do so. In that case, investors can buy preferred stock through the securities company by paying in cash, by online transfer and so on…

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