Preferred Stock

Preferred Stock is the most common example of a hybrid security (‘hybrid financial instrument’). Like debt, it entitles is owners to regular payments - dividends - which must be paid before owners of the common stock can get theirs (but after debt holders receive their interest payments).

The dividend on preferred shares is usually specified as a percentage of their par value, or as a fixed amount (for example, Pacific Gas & Electric 6% Series A Preferred). Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index (such as LIBOR).

But unlike debt, preferred shares have unlimited life span, which makes preferred shares similar to common ones. Also, if your company defaults on its debts payments (interest and/or principal), it can be forced into bankruptcy.

If it defaults on its dividend payments to its preferred stockholders, in most cases the latter will simply get voting rights or will have their preferred stock converted to common. Regular preferred shares have no voting rights associated with them; however, some preferred shares have special voting rights to approve extraordinary events (such as the issuance of new shares or approval of the acquisition of a company) or to elect directors.

Preferred shares is a very versatile instrument; they may specify nearly any right conceivable. In the U.S. they normally carry a call provision, enabling the issuing corporation to repurchase the share at its (usually limited) discretion.

There are many categories of preferred stock (and Wall Street wizards come up with new ones all the time) - prior preferred stock, preference preferred stock, cumulative and non-cumulative preferred stock, participating preferred stock, exchangeable preferred stock (for some security other than common stock), putable preferred stock and others.  

Of all these, the most interesting is the convertible preferred stock which holders can exchange for a predetermined number of the company's common-stock shares. It is a one-way deal; one cannot convert the common stock back to preferred stock.

This exchange may (but usually does not have to) occur under certain conditions (among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share or a certain price per share for the common stock).

Why would you want to issue preferred shares? Because from financial valuation standpoint (NPV, IRR, etc.) this financing option is better than any other – bank loan, bond issue, etc. Or issuing common stock.

This statement you must, of course, prove with the solid financial model and all necessary supporting documentation. It must also prove that your investment project that you are financing with your preferred stock, is financially and economically acceptable.

Specifically, preferred stock carries less risk than a bank loan or bond issue - in some cases, a company can defer dividends by going into arrears with little penalty or risk to its credit rating (although it will negatively affect the overall company image in the eyes of its creditors and other stakeholders). With debt financing, payments are required; a missed payment would put the company in default.

And, unlike with the common stock issue, you will not have to dilute your capital and acquire additional shareholders, who might become quite a nuisance.

Occasionally companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a ‘poison pill’ (or forced-exchange or conversion features) which are exercised upon a change in control.

Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank checks" are often used as a takeover defense; they may be assigned very high liquidation value (which must be redeemed in the event of a change of control), or may have great super-voting powers.