Contents of this article
What Is Preferred Stock?
Preferred stock (preferred shares) is also a type of stock, and a stock is an asset representing ownership of part of a company’s share capital. However, preferred shareholders enjoy certain “preferences” over common shareholders, with advantages in dividends, voting rights or a priority claim on capital over common stock if the company goes bankrupt.
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.
Types of Preferred Stock
Besides a priority claim on capital, preferred stock can carry other preferences, as with the types described below.
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
While a common share carries 1 vote, each voting preference share carries more than 1 vote, as specified in 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 Do You Buy and Sell Preferred Stock?
Unlike common stock, not every company issues preferred stock, and in Vietnam it does not trade on the centralized exchange. So you can only buy preferred stock when a company announces an issue, and you can register to subscribe through a securities company.
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