
Investors who acquire preferred stock can reduce risk with strategies.
Preferred stockholders are paid dividends before common stockholders, giving them a higher claim on assets.
By acquiring preferred stock, investors can reduce their risk of loss by having a higher priority claim on assets in the event of bankruptcy.
In some cases, preferred stockholders may also have a liquidation preference, meaning they receive a higher payment than common stockholders in the event of liquidation.
What Is a Security?
A security is essentially a financial instrument that represents an ownership interest in a company.
Preferred stock is a type of security that offers a higher claim on assets and earnings than common stock.
It's often considered a hybrid security, combining features of debt and equity.
Benefits of Securities
As an investor who acquires preferred stock, you're likely looking for ways to maximize your returns while minimizing risk. Preferred securities can offer a potential yield that's attractive to income-seeking investors.
One key benefit of preferreds is their potential yield, which can be higher than that of bonds or other fixed-income investments.
By incorporating preferreds into your portfolio, you can potentially reduce your reliance on other investments that may be more volatile.
Low correlations between preferreds and other investments can also help to reduce overall portfolio risk.
Preferreds can offer tax-advantaged income potential, which can be beneficial for investors in higher tax brackets.
Here are the four key benefits of preferred securities:
- Potential Yield
- Tax-advantaged Income Potential
- Low Correlations
- Less Volatility
By understanding these benefits, you can make more informed decisions about incorporating preferreds into your investment strategy.
Investing in Preferred Stock
Investing in preferred stock can be a smart move for those looking to generate income with less volatility. Preferred shares have historically had a lower volatility profile than common stocks, making them an attractive option for investors seeking stability.
According to the ICE BofA Hybrid Preferred Securities Index, preferreds have a yield of 6%+ for a group of primarily investment-grade securities, making them a potential addition to a portfolio seeking income generation.
In terms of correlations, preferreds have low historical correlations to traditional stocks and bonds, indicating that their return patterns may be differentiated throughout certain market environments. This makes them a potential portfolio diversifier, particularly when combined with other assets that have low correlations to each other.
Here are some key features of preferred shares to consider:
- Convertible: Preferred shares can be converted into a certain number of common shares.
- Callable: A call option lets the issuer buy preferred shares at a preset price or par value after a certain date.
- Participating: Preferred shareholders may receive a portion of dividends given to common shareholders.
- Cumulative: Preferred shareholders may have the right to receive payment before the dividend for common shareholders resumes.
- Preference: The highest priority may be first, followed by first preference, second preference, etc.
Capturing Potential Yield
Preferred stock offers a compelling combination of income generation and potential for capital appreciation. The ICE BofA Hybrid Preferred Securities Index, which consists entirely of investment-grade rated securities, boasts a potential yield of 6% or more. This makes preferred stock a worthwhile consideration for investors seeking a reliable source of income.
In comparison to other income-generating options, preferred stock holds its own. It offers a similar yield to high-yield bonds, but with the added benefit of being invested in a primarily investment-grade security.
Investors who opt for preferred stock can expect to receive profits from the corporation's activities, making it an attractive option for those seeking regular income.
Targeting Portfolio Diversification
Preferred stock can be a valuable addition to a diversified portfolio. Its unique characteristics make it an attractive option for investors seeking to balance risk and return.
The key to unlocking the diversification benefits of preferred stock is understanding its correlation profile. This measures how much the returns of preferred stock move in sync with other investments. According to the data, preferred stock has a low correlation to traditional stocks and bonds, indicating that its return patterns may be differentiated throughout certain market environments.
One way to visualize this is to look at the correlation between preferred stock and other asset classes. A table showing the historical correlation between preferred stock and other investments might look something like this:
This low correlation means that preferred stock can help reduce the overall risk of a portfolio by spreading investments across different asset classes. By including preferred stock in a standard 60/40 equity/bond allocation, investors can potentially improve the diversification profile within the bond allocation and make the total portfolio more equity sensitive.
However, it's essential to remember that diversification does not ensure a profit or guarantee against loss. Investing always involves risk, including the risk of loss of principal.
Later Financing Rounds Can Get Trickier
Later financing rounds can get trickier, especially if your company has struggled to hit milestones. Investors might ask for 2x or 3x liquidation preferences, meaning they would receive twice or three times their original investment before common shareholders are paid.
This all but guarantees that employees and founders won’t ever see much for their equity, unless they manage to turn the ship around. Investors might also ask for anti-dilution provisions to protect their ownership percentage from being diluted in future funding rounds.
These provisions are designed to maintain an investor’s stake in the company through formulas that turn each preferred share into more than one common share. Exactly how much more depends on the situation and the method specified in the anti-dilution agreement.
Here's an example of how this could play out:
Shares Features
Preferred stock has a unique mix of characteristics that distinguish it from debt and common stock.
One of the key features of preferred stock is that it's convertible into a certain number of common shares, which means investors can swap their preferred shares for common stock at a later date.
Preferred shares can also be callable, which means the company can buy them back at a preset price or par value after a certain date.
Some preferred shares have a participating feature, which allows preferred shareholders to receive a portion of dividends given to common shareholders.
Preferred shares can be cumulative, meaning that if a corporation is experiencing financial difficulties and must suspend its dividend, preferred shareholders may have the right to receive payment before the dividend for common shareholders resumes.
In the event of a liquidity event, preferred shareholders have a bigger claim on the company's assets than regular stockholders but a smaller claim than bondholders.
Here are the key features of preferred shares:
- Convertible: Can be exchanged for common stock
- Callable: Can be bought back by the company at a preset price
- Participating: Eligible to receive a portion of dividends
- Cumulative: May receive payment before common shareholders in times of financial difficulty
- Preference: Has a higher priority than common stock in a liquidity event
Tldr:
Preferred stock is an equity type representing a corporation's ownership and the right to receive profits from its activities. It's obtained by investors in primary sales of equity in equity financing rounds (series A and onwards) or through secondary markets.
In most cases, preferred investors have no or restricted voting rights in corporate governance, meaning they have limited say in how the company is run.
Preferred shareholders have a bigger claim on the company's assets than regular stockholders, but a smaller claim than bondholders, in case of a liquidity event.
Investors are attracted to preferred stock because it has qualities of both bonds and common shares. For instance, preferred stock receives a set dividend, whereas common stock investors are not necessarily guaranteed to receive a dividend.
Here are the key characteristics of preferred stock:
- Preferred stock is an equity type representing a corporation's ownership.
- It's obtained by investors in primary sales of equity in equity financing rounds or through secondary markets.
- Preferred investors have no or restricted voting rights in corporate governance.
- Preferred shareholders have a bigger claim on the company's assets than regular stockholders.
- It has qualities of both bonds and common shares.
Strategies for Investing
Investors who acquire preferred stock can benefit from integrating it into their portfolios. Preferreds offer relatively low historical correlations to traditional stocks and bonds, at 0.46 and 0.41, respectively.
To reduce equity volatility, preferreds can be a good option. They have a beta of 0.61 to stocks, making them a more stable investment.
By incorporating preferreds into your portfolio, you can achieve income diversification and potentially reduce your exposure to market fluctuations.
How to Allocate
Investors can allocate to preferreds by considering their unique features and benefits. Preferreds offer attractive income diversification, with relatively low historical correlations to traditional stocks and bonds.
Their low correlation to traditional stocks and bonds - 0.46 and 0.41, respectively - makes them a great addition to a portfolio. This means they can help reduce overall portfolio risk.
One key advantage of preferreds is their ability to generate attractive potential income per unit of risk. They have a yield per unit of trailing 36-month volatility of 0.43, compared to 0.29 for long-term Treasuries and 0.23 for US large-cap dividend equities.
To illustrate this, consider the following comparison of yields per unit of volatility:
By allocating to preferreds, investors can potentially reduce equity volatility and increase overall portfolio income generation.
Reduce Investor Risk Without Giving Up Too Much
Reducing investor risk without giving up too much is crucial for startups. This can be achieved by understanding the terms of preferred stock, which mitigate investor risk.
Preferred stock is a type of stock that investors receive in exchange for their investment. It's essential to understand what it means and how it's structured.
In venture capital, investors usually get preferred shares, while the company's founders and employees get common shares. This is a common practice in Silicon Valley.
Deal terms have become increasingly standardized, favoring founders. Most venture capitalists will ask for and receive a liquidation preference called "1x, non participating." This means they will receive a dollar back for every dollar invested, a full recouping of their money.
However, entrepreneurs should be cautious not to give up too much in the process of negotiating for higher valuations. This can lead to unfavorable liquidation preferences.
To illustrate the importance of understanding liquidation preferences, consider the following example:
In this example, common stockholders with 80% ownership will receive the same amount as preferred shareholders with 20% stake in the worst-case scenario. This highlights the importance of understanding the terms of preferred stock.
By being aware of these terms and negotiating effectively, entrepreneurs can reduce investor risk without giving up too much.
Key Considerations
As you consider the terms of your investment, it's essential to understand the implications of acquiring preferred stock. Preferred stock comes with special privileges that your common stock doesn't have.
Your VCs will get preferred stock, which means they'll have priority over common stockholders in certain situations. This can include liquidation preferences, which reduce investor risk by ensuring they receive a certain amount of money before common stockholders.
Don't underestimate the importance of liquidation preferences - they can significantly impact the outcome in different scenarios.
Key Takeaways
If you're about to negotiate with VCs, it's essential to understand the difference between preferred and common stock. Preferred stock comes with special privileges that your common stock doesn't.
Your VCs will get preferred stock, which means they'll have priority over common stockholders in case the company is liquidated. This reduces investor risk, but it's crucial to understand how it'll affect different scenarios.
Don't try to navigate these complex negotiations alone – consult with an experienced advisor before heading to the table.
Clarify Taxation Gray Areas
Issuing SAFE Preferred Stock can provide an alternative to the uncertainty surrounding the tax treatment of SAFEs. This approach combines the benefits of SAFEs with the added certainty of tax treatment.
SAFE Preferred Stock is essentially a series of preferred stock included in the Certificate of Incorporation and on the corporation's cap table.
Its "form" is that of "stock" rather than a hybrid instrument/agreement, which can help clarify its tax treatment.
By structuring it as a series of preferred stock, you can take advantage of the best features of the SAFE while minimizing tax uncertainty.
The benefits of preferred securities, such as potential yield and tax-advantaged income potential, can be attractive to investors.
Here are four key aspects of preferred securities that can help you understand their potential benefits:
- Potential Yield
- Tax-advantaged Income Potential
- Low Correlations
- Less Volatility
Mismatched Securities
Mismatched Securities can lead to valuation issues, especially when management receives a different class of equity than the PE firm.
In such cases, it's necessary to value the rollover security to establish the allocable purchase under ASC 805. This is crucial when the amount of rollover equity is material to the transaction.
Consider a transaction where the PE investor receives Preferred A shares for its $40 million investment, paying $1,000 per share. This is a common scenario.
The rollover equity holders, on the other hand, receive Preferred B shares for their investment valued at $1,000 per share, just like the PE investor. However, the A and B shares have identical terms, except for one key difference: the A shares are senior to the B shares in liquidation.
This difference in seniority creates a material economic difference between the A and B shares, making the "price" assigned to the B shares in the transaction not representative of their fair value for ASC 805 valuation purposes.
Understanding VC Deals
When you issue preferred stock to VCs, they get preferential treatment over other investors in specific situations. They receive special rights that can help mitigate their risk.
Liquidation preferences are a common and important right that ensures investors get paid first in case your company goes out of business or sells for less than its value. The fine print of your term sheet will determine how much, if any, remains for you and your employees.
Anti-dilution provisions help shield investors from their stock losing value by preventing dilution when the total number of shares in a company increases. This happens when a new financing round occurs and investor's share of the company's ownership goes down.
Pro rata rights allow investors to take part in one or more future rounds of funding and maintain their ownership stake in the company. This means they can keep their share of the company even if new investors come in.
Here are the privileges that come with owning preferred shares:
- Anti-dilution provisions
- Liquidation preferences
- Pro rata rights
- Voting rights
Potential Pitfalls
Giving up too much can hurt later. Founders who agree to unfavorable terms, such as 3x preferred participating rights, are often desperate for money and may not be in a strong negotiating position.
Cash-strapped founders must make these decisions very carefully, as they could have dire consequences later. In fact, a high liquidation preference can make it difficult for founders to see any upside from a modest acquisition offer, even one that would have been life-changing for them and their employees.
Beware of Double Dipping
Double dipping is a sneaky way investors can take advantage of a company's lack of leverage.
In a liquidation event, an investor with participating preferred rights is first in line to recoup their initial investment.
They get to take their original investment off the top, and then pocket an additional share proportional to their percentage ownership stake in the company.
This is known as participating preferred, and it's the thing to be wary of.
If a company sells for $100 million, an investor with participating preferred shares might take their original $20 million investment off the top and then take 20% of the remaining $80 million.
Common shareholders could end up with as little as 30 or 40 cents on the dollar in later rounds.
Overcommitting Can Have Consequences
Founders who agree to give up too much can hurt their company later on. This is especially true for those who are desperate for money in a bull market.
Terms of preferred shares are negotiated between founders and investors, and giving up 3x preferred participating rights is often a sign of desperation. David Pakman, a partner at Venrock, says such terms are very rare in a bull market.
Cash-strapped founders must make these decisions carefully, as they can have dire consequences later. Consider this scenario: you do a financing in desperation, agree to a high liquidation preference, and then get a modest acquisition offer.
SAFE for Startups
SAFE Preferred Stock is a popular choice for startups, and for good reason. It's a flexible and customizable way to raise capital.
In Delaware, SAFE Preferred Stock can be included as an initial series of preferred stock in a corporation's Certificate of Incorporation. This is typically done after issuing founder common stock.
The Certificate of Incorporation also includes the concept of "blank-check preferred", which allows the Board of Directors to adopt the terms of the corporation's first priced round of preferred stock without the vote of holders of SAFE Preferred Stock.
This concept can be avoided if founders are okay with holders of SAFE Preferred Stock having voting rights with respect to amending the initial Certificate of Incorporation.
A Certificate of Incorporation that includes a class of SAFE Preferred Stock and incorporates Delaware "blank check preferred" is a good example to follow.
Here are some examples of SAFE Preferred Stock documents:
- An example of a Certificate of Incorporation that includes a class of SAFE Preferred Stock and incorporates Delaware "blank check preferred."
- An example of a SAFE Preferred Stock Purchase Agreement.
- An example of a Certificate of Designations previously filed with the Delaware Secretary of State establishing a series of preferred stock.
These examples can be used as a starting point for creating your own SAFE Preferred Stock documents, but be sure to customize the terms to fit your startup's needs.
Rollover Equity
Rollover equity is a common arrangement in private equity deals. It allows certain equity holders to roll a portion of their ownership stake into the new equity capital structure, rather than receiving cash proceeds.
This arrangement is attractive to private equity investors because it reduces their cash outlay. It also helps align investor and management team objectives, as the latter continues to have "skin in the game" post-acquisition.
Rollover equity can be appealing to those rolling their equity because it allows them to receive partial liquidity for their investment. It also enables them to participate in further upside.
From a tax perspective, rolling equity may be attractive to the sellers.
Sources
- https://www.ssga.com/us/en/intermediary/insights/preferred-securities-what-they-are-and-how-they-work
- https://www.svb.com/startup-insights/startup-equity/startup-founders-should-know-preferred-stock/
- https://capbase.com/preferred-stock-quick-guide-for-startup-founders/
- https://frostbrowntodd.com/user-guide-for-safe-preferred-stock-with-examples/
- https://www.valuationresearch.com/insights/rollover-equity-private-equity-deals/
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