There are several ways companies can raise funds, including stocks and bonds. Corporations can also choose which kinds of stock they offer to the public. They base that decision on the type of relationship they want with shareholdersthe cost of the issue, and the need prompting the financing.
When it comes to raising capital, some companies elect to issue preferred stock in addition to common stock. However, the reasons for this strategy vary among corporations.
Key Takeaways
- Preferred shares are an asset class somewhere between common stocks and bonds, so they can offer companies and their investors the best of both worlds.
- Companies can get more funding with preferred shares because some investors want more consistent dividends and stronger bankruptcy protections than common shares offer.
- Some companies like to issue preferred shares because they keep the debt-to-equity ratio lower than issuing bonds and give less control to outsiders than common stocks.
Preferred Share Basics
Preference shares act as a hybrid between common stocks and bond issues. As with any produced good or service, corporations issue preferred shares because consumers—investors, in this case—want them. Investors value preference shares for their relative stability and preferred status over common shares for dividends and bankruptcy liquidation. Corporations mostly value them as a way to obtain equity financing without diluting voting rights and for their callability. Preferred stocks are also occasionally useful to firms trying to fend off hostile takeovers.
Although preferred share prices are more stable than common stocks, they are also much less stable than investment-grade bonds.
In most cases, preference shares comprise a small percentage of a corporation’s total equity issues. There are two reasons for this. The first is that preferred shares are confusing to many investors (and some companies), which limits demand. The second is that common stocks and bonds are generally sufficient options for financing.
Why Investors Demand Preference Shares
Most shareholders are attracted to preferred stocks because they offer more consistent dividends than common shares and higher payments than bonds. However, these dividend payments can be deferred by the company if it falls into a period of tight cash flow or other financial hardship. This feature of preferred stock offers maximum flexibility to the company without the fear of missing a debt payment. With bond issues, a missed payment puts the company at risk of defaulting. That would cause a credit downgrade and could even force a bankruptcy.
Some preferred shareholders also have the right to convert their preferred stock into common stock at a predetermined exchange price. In the event of bankruptcy, preferred shareholders receive company assets before common shareholders.
Why Corporations Supply Preference Shares
Companies that offer preferred shares instead of issuing bonds can accomplish a lower debt-to-equity ratio. That allows them to gain significantly more future financing from new investors. A company’s debt-to-equity ratio is one of the most common metrics used to analyze the financial stability of a business. The lower this number is, the more attractive the company looks to investors. Additionally, bond issues can be a red flag for potential buyers. The strict schedule of repayments for debt obligations must be maintained, regardless of the company’s financial circumstances. Preferred stocks do not follow the same guidelines of debt repayment because they are equity issues.
Corporations also might value preference shares for their call feature. Most, but not all, preferred stock is callable. After a set date, the issuer can call the shares that pair value to avoid significant interest rate risk or opportunity cost.
Although common stock is the most flexible type of investment offered by a company, it gives shareholders more control than some business owners may feel comfortable with. Owners of preference shares do not have normal voting rights. That allows a company to issue preferred stock without upsetting controlling balances in the corporate structure. Common stock provides a degree of voting rights to shareholders, allowing them an opportunity to impact crucial managerial decisions. Companies that want to limit the control they give to stockholders while still offering equity positions in their businesses may, therefore, turn to preferred stock.
Finally, some preference shares act as “poison pills” in the event of a hostile takeover. They often take the form of a detrimental financial adjustment with the stock that can only be exercised when controlling interest changes.
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