Understanding Preferred Stock: A Comprehensive Guide for Employers and Startups

Casey Fenton

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In the high-stakes game of building a successful business, attracting talent and securing necessary funding are two cards you want to have up your sleeve. Equity compensation often serves as that winning hand, with preferred stock being one of the aces. But what exactly is preferred stock, and how does it stack up as a strategic move for employers and startups?

What Preferred Stock is All About

When you hear about stocks, it's often the common shares that spring to mind. But in actuality, the equity market extends beyond these standard investments. Lying somewhere between the worlds of debt and equity financing, preferred stock represents a unique form of ownership in a corporation that endows certain preferential rights to its holders, earning its name.

In contrast to common stock, preferred shares do not confer voting rights on their holders in most cases. The trade-off, however, comes in the form of prioritized dividends and claims on assets. In essence, preferred stock is a type of equity investment that is 'preferred' because it has a higher claim on the company's earnings and assets than common stock.

If a company declares dividends, preferred stockholders are first in line to receive them. These dividends are often set at a fixed rate and can be a boon during prosperous times. However, the company is not obligated to pay these dividends if it falls on hard times. But if dividends have been omitted, these unpaid dividends, called "cumulative dividends", often accumulate and must be paid out before any dividends on common shares.

During liquidation or bankruptcy, preferred shareholders also take precedence. After debt holders have been paid off, any remaining assets are first allocated to the preferred shareholders. This claim on assets extends up to the par value of the preferred stock, after which any remaining assets are divided amongst the common shareholders.

In essence, preferred stock can be viewed as a hybrid form of financing—it bears similarities to both common stock and bonds. Like common stock, it represents ownership in a company; like bonds, it provides a fixed income stream and has a senior claim on assets. But remember, despite the seemingly higher status of preferred stock, each form of equity has its own place and purpose in the financial strategy of a business.

And therein lies the fundamental nature of preferred stock—a hybrid security offering some of the growth potential of common stock, alongside the relative security of a bond. It's an equity class that, when used judiciously, can serve as a powerful financial tool in a company's capital structure.

Benefits of Preferred Stock to Businesses

For startups and businesses, issuing preferred stock comes with several potential benefits.

1. Capital Acquisition

Preferred stock allows you to raise capital without giving away control of the company. Because preferred stock usually does not carry voting rights, you retain control of your company's future.

2. Investor Appeal

Preferred stock is appealing to investors because of its hybrid nature—it combines the potential for capital appreciation of common stock with the stability and dividends of bonds. It could make your company more attractive to potential investors.

2. Flexibility

The terms of preferred stock are flexible and can be designed to fit the specific needs of your company and your investors.

Who Are Eligible for Preferred Stock?

When it comes to deciding who is eligible for preferred stock, the choice is yours. You may opt to offer preferred stock to a broad base of employees or restrict it to certain tiers or roles. You might also issue preferred stock to outside investors. After all, preferred stock can be an incentive to attract and retain high-quality talent and investor capital.

Characteristics of Preferred Stock

Preferred stock possesses unique attributes that give it appeal and utility to both the issuing company and the recipient investor or employee.

Dividend Preference

One of the defining features of preferred stock is its dividend preference. Unlike common stock dividends, which can fluctuate with a company's profitability, preferred dividends are typically set at a fixed rate. This means preferred shareholders are assured a steady stream of income. Moreover, in the event of dividends being declared, preferred shareholders are at the front of the line, receiving their dividends before common shareholders see a penny.

Liquidation Preference

In the unfortunate event of a company's liquidation or bankruptcy, preferred stockholders find security in their liquidation preference. This ensures that after all debts have been paid, the next slice of the remaining assets goes to preferred shareholders. Only after they've been paid to common stockholders receive their shares.

Convertible Feature

Some preferred stock comes with the option of conversion. Convertible preferred stock provides the shareholder the right to convert their preferred shares into a predetermined number of common shares after a specified date. This offers a potential upside if the company's common share price rises significantly.

Voting Rights

Typically, preferred stockholders do not possess voting rights. This might seem like a drawback, but it's often a trade-off companies make to offer the other benefits of preferred stock without ceding control of the company.

Two Types of Preferred Stocks

Beyond these common characteristics, preferred stock can be broken down into two main types. These variations offer different risk and reward profiles and can be utilized strategically by companies and investors alike.

Non-participating Preferred Stock

This type of preferred stock offers a simpler reward structure. With non-participating preferred stock, holders have the right to receive their initial investment (the purchase price) back, along with any accrued dividends, in the event of a company's liquidation. However, after these are paid, the remaining proceeds go to the common stockholders. This means that non-participating preferred shareholders have a cap on their potential return.

Participating Preferred Stock

As the name implies, participating preferred stock lets its holders participate further in the company's success. Beyond the return of their initial investment and accrued dividends, participating preferred shareholders also get a share of any remaining liquidation proceeds. This 'participation' alongside common shareholders can lead to a significantly higher return if the company performs exceptionally well. It's a more complex instrument but offers an enticing upside to investors.

Risks Involved in Preferred Stock

Issuing preferred stock can be an effective way to raise capital and incentivize employees. However, like any strategic decision, it also carries certain risks. Understanding these risks is crucial for businesses to make informed decisions and mitigate potential pitfalls.

1. Financial Commitment

The primary risk of issuing preferred stock involves the financial commitment that comes with it. Preferred stockholders have a right to dividends, which are often set at a fixed rate. While these dividends can be deferred if the company falls on hard times, they usually accumulate and must be paid out before any dividends can be issued to common shareholders. Therefore, the obligation to pay dividends on preferred stock can place a strain on your company's finances.

2. Limited Upside for Employees

From the perspective of employees, preferred stock might not be as appealing as common stock. While the preference features provide a level of protection, they also cap the potential upside. If your company performs extremely well, employees with common stock may see a larger return on their investment than those with preferred stock.

3. Conversion Risk

If you've issued convertible preferred stock, there's a risk associated with the conversion feature. If the common stock price rises significantly, holders of convertible preferred stock may choose to convert their shares. This can lead to stock dilution for existing common shareholders, potentially diluting control over the company.

4. Higher Expectations from Investors

Investors who purchase preferred stock typically have higher expectations for returns, given the preferential treatment in dividends and liquidation. This could put additional pressure on your company to meet these expectations, which might divert focus and resources from other areas of the business.

5. Complexity and Cost

The issuance of preferred stock is often more complex than that of common stock. It may require more sophisticated financial and legal advice, potentially leading to higher issuance costs. Furthermore, the ongoing management of preferred stockholders can be more demanding, particularly if the stock is convertible or participating.

While issuing preferred stock can be an effective way to attract talent and investment, it's important to weigh these benefits against potential risks. Consulting with a financial advisor or legal counsel can help you navigate these complexities and ensure that the structure of your equity offerings aligns with the long-term goals of your company.

Preferred Stock vs RSUs

Preferred stock and RSUs are both forms of equity compensation, but they differ significantly.

Restricted Stock Units (RSUs) are a form of compensation offered by an employer to an employee in the form of company shares. The shares are "restricted" because they're subject to a vesting schedule.

While both preferred stocks and RSUs provide an ownership stake in the company, preferred stock typically offers more advantages like dividend and liquidation preferences. However, unlike RSUs, preferred stocks usually do not come with voting rights.

Additionally, RSUs tend to be less complex to manage from an administrative perspective, since there are fewer variables like dividends and liquidation preferences to manage.

As a startup founder or employer, your decision between issuing preferred stock or RSUs will depend on your company's specific needs and circumstances, as well as the preferences of your employees or potential investors.

Bottomline

Just as in a high-stakes card game, dealing the right hand in business requires both strategy and understanding. Preferred stock presents a unique blend of features that when played correctly, can be a potent tool in attracting top talent, securing necessary funding, and aligning the interests of all stakeholders. However, like any card game, the rules and risks must be understood fully to maximize its potential benefits. With this knowledge, you will be well equipped to play the hand of preferred stock confidently, leveraging it as a strategic move towards building a winning business.

Alternatively, if you wish to know more about RSU plans to compare it with your current equity of choice, book a demo with Upstock today and see the difference.

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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