Preferred Shares 101: Benefits and Risks Explained

Preferred shares offer a unique investment opportunity, but it's essential to understand the benefits and risks involved. They typically have a higher claim on assets and dividends compared to common shares.

Preferred shareholders usually have priority over common shareholders in dividend payments, which can provide a more stable income stream.

In exchange for this priority, preferred shareholders often give up voting rights, which can limit their influence in company decision-making.

Preferred shares can be a good choice for investors seeking regular income and a relatively lower risk profile.

Preferred stock is a way for companies to raise money, ranking below senior secured debt in the event of bankruptcy. It's a hybrid investment that combines characteristics of common stocks and bonds.

The price of preferred shares is typically less volatile than common stock, but it's still sensitive to fluctuations in interest rates. When interest rates rise, the price of preferred shares usually falls as their yields increase.

Preferred stock regularly pays income in the form of a dividend, unlike bonds which pay interest and the return of principal at maturity. This makes it an attractive option for investors seeking regular income.

Buyers of preferred stock are typically looking for income, not capital appreciation. In fact, preferred stock usually doesn't realize the same type of capital appreciation as common stock.

With preferred stock, investors usually don't have voting rights, unlike common shareholders. If you're used to voting your shares, you'll notice a difference with preferred stock.

Venture capitalists demand liquidation preferences to mitigate their risk, which means they get paid back first in case of a company's liquidation. This reduces the risk for investors, but it's essential to understand the implications of liquidation preferences in different scenarios.

The liquidation preference is a key aspect of preferred stock, and it ensures investors receive their payment before founders and employees. This is why it's crucial to negotiate the fine print of your term sheet carefully.

Preferred stock can be less risky than common stock, but it still carries more risk than a bond. Payments of interest or dividends on preferred stock are required to be paid before any payments to common shareholders, making it a safer bet for investors.

In the event of a company's bankruptcy, bondholders get paid before preferred shareholders, which is why preferred shares tend to yield more. This is a crucial consideration for investors looking to mitigate their risk.

Here are some key points to keep in mind:

Preferred stock offers a more familiar trading experience for investors, allowing them to enter a ticker symbol and trade shares in a self-directed manner, unlike traditional bonds that often trade over the counter.

The buy-in for preferred stock is lower, with some issues starting at just $25 per share, compared to the typical $1,000 par value of corporate bonds.

Preferred shareholders have seniority over common shareholders, meaning companies have a greater obligation to pay preferred dividends.

Preferred stock comes with its own set of risks, including lower seniority than bondholders, which means they get paid after bondholders in case of bankruptcy.

If a company goes into liquidation, bondholders get paid first, which is why preferred shares tend to yield more. This is a crucial consideration for investors.

Low liquidity can also be a risk, especially if you're trying to sell your shares. With some preferred stocks trading only a few thousand shares per day, you may not get a good price.

Wide spreads between bid and ask prices can make it difficult to sell your shares at a fair price. This can be frustrating for investors who need to liquidate their assets quickly.

Dividend payments are not guaranteed and can be discontinued at any time, leaving investors with a reduced income. This is a risk that investors should carefully consider before investing in preferred stock.

Investors want to mitigate their risk, and that's why they demand liquidation preferences in venture deals. This means they get paid first in case of a liquidation or sale of the company.

VCs won't hand over money in exchange for common shares, which is why preferred stock is nearly always issued. Preferred stock gives investors preferential treatment over other investors in specific situations.

To understand what liquidation preferences mean, you need to know that they ensure investors get paid first. The fine print will determine how much, if any, remains for you and your employees.

Preferred stock has some risks, including lower seniority than bondholders and low liquidity. This means bondholders get paid before preferred shareholders in case of bankruptcy, and you might not get a good price if you want to sell your shares.

Here are some key things to consider when dealing with preferred stock:

Deal terms are becoming more standardized, favoring founders with more leverage in negotiations. This means that venture capitalists are often willing to accept a 1x, non-participating liquidation preference, which allows them to receive back their original investment while also giving them the option to convert to common stock.

In some cases, entrepreneurs may give up more favorable liquidation preferences in exchange for higher valuations, which can ultimately be a bad trade. I've seen companies make this mistake, and it's often a costly one.

Later financing rounds can get tricky, especially if your company has struggled to hit milestones. Investors may ask for 2x or 3x liquidation preferences, which can guarantee that employees and founders won't see much for their equity unless they turn the company around.

Deal terms are becoming more standardized, which is good news for founders. This means that venture capitalists are often asking for and receiving a liquidation preference called "1x, non participating".

This type of liquidation preference is a multiple of the initial investment, so investors will receive a dollar back for every dollar invested. The "non participating" part means that investors have a choice: they can receive their original investment back or convert their preferred stock into common stock and share in the proceeds according to their equity ownership.

The leverage is with the entrepreneur, as there's a ton of capital available and a lot of competition for deals. This competition means that investors are often willing to accept standard terms.

However, entrepreneurs should be careful not to get too fixated on maximizing their company's valuation in a given round. Giving up more favorable liquidation preferences can end up being a bad trade.

In fact, it's been seen that companies raise money and negotiate for higher valuations, only to give up more favorable liquidation preferences in the process. This can leave founders and employees with little to no equity unless they manage to turn the company around.

As interest rates fluctuate, it's essential to understand how they impact the market price of preferred stock. Rising interest rates can make your fixed-income investment less valuable, causing its market price to fall. This is because investors can easily obtain a new bond or preferred stock with a higher interest rate, making your 5% preferred stock less attractive.

Interest rates up, market prices down - it's a simple equation. If an investor buys a 5% preferred stock at par and interest rates rise to 7%, the stock's market price will likely fall to around $70 per share. This is because the yield on the investment increases to 7.14%, making it more attractive to buyers.

Conversely, falling interest rates can make your fixed-income investment more valuable, causing its market price to rise. If interest rates fall to 3% and an investor offers to sell a 5% preferred stock for $150, the current yield will be 3.33%.

Here's a summary of how interest rates impact market prices:

This means that if you're a preferred stockholder, you can potentially benefit from falling interest rates by selling your stock at a premium price. Just remember, the yield and market price are inverses, so if the price increases, the yield will decrease, and vice versa.

Liquidation preferences are a crucial aspect of preferred stock that mitigate the risk investors face by ensuring they get paid first in case of company liquidation or sale.

In the worst-case scenario, investors can choose to receive a fixed amount, known as the liquidation preference, regardless of the company's valuation. This means they'll get paid before founders and employees.

For example, if a company is sold for $2 million and the investors have a 1x liquidation preference, they'll receive $500,000, which is the same amount as their initial investment.

Here's a breakdown of how liquidation preferences work in different scenarios:

In the worst-case scenario for founders and employees, the liquidation preference can be as high as 2x, meaning they'll get paid the same amount as the investors, even if the company is sold for less than its initial valuation.

Preferred stock makes cash dividend payments typically on a quarterly basis, although some issuers opt for annual or semi-annual payments. The Board of Directors must approve the dividend payment.

The dividend rate is based on the par value, which is the original price at which the preferred stock is issued. Typically, the par value is $100, although it could differ depending on the issuer's preference.

The dividend rate is a fixed percentage of the par value, and it determines the dividends paid to investors. For example, if ExxonMobil issues a $100 par, 5% preferred stock, shares are sold at par ($100) and will pay $5 every year to their investors.

The dividend rate remains the same, regardless of the market price of the preferred stock. However, the yield, which is the rate of return an investor receives, can fluctuate depending on the market price.

The current yield is a more accurate representation of an investor's return, as it reflects the rate of return based on the current market price. It's calculated by dividing the annual income by the market price.

Here's a quick summary of how trading at different prices affects the yield:

If a preferred stock trades at a price below par, it's selling at a discount, and the yield will be higher than the dividend rate. If it trades at par value, the yield will be equal to the dividend rate. If it trades at a price above par, it's selling at a premium, and the yield will be lower than the dividend rate.

For example, if an investor purchases a 5%, $100 par preferred stock at a discount of $80, the yield will be higher than the dividend rate.

To buy preferred shares, you'll likely go through a broker, who can help you place a trade for the number of shares you'd like to purchase.

Most online brokers have cut trading commissions to zero, so you won't have to worry about high costs.

Not all companies offer preferred stock, so be sure to check what's available through your broker before making a purchase.

You can place a trade for the number of shares you'd like to buy, but keep in mind that trading fees will likely be higher if you go through a traditional broker.

Preferred shares can be a bit tricky, and here's what you need to know about the downsides.

One of the biggest cons of preferred shares is that they can have greater price volatility than preferred stock.

In other words, the value of preferred shares can fluctuate more wildly than preferred stock, making it harder to predict what they'll be worth in the future.

You may not receive dividends with preferred shares, which can be a major drawback for some investors.

Dividends are paid out to preferred shares first, then to common shares, so if there's not enough money to go around, common shareholders might miss out.

In the event of a liquidation, preferred shares have lower priority than preferred stock to receive a payout.

Here's a quick summary of the cons: