Preferred stock

Preferred stock is a unique financial tool used by companies to raise money. It is often called a hybrid instrument. This term describes how it combines features of two different things. It acts like equity, which means owning a part of a company. It also acts like debt, which is similar to a loan. Because it sits between these two categories, it has a specific rank. Preferred stock is senior to common stock. This means preferred holders have higher priority for certain payments. However, it is subordinate to bonds. If a company runs out of assets, bondholders are paid before preferred stockholders.

One of the most important features is the preference in dividends. A dividend is a payment made to shareholders from company profits. A company must pay the stated dividends on preferred stock before it pays common stock. There are two main types of dividend rules. Cumulative preferred stock requires the company to pay missed dividends later. These missed payments are called dividends in arrears. If a company skips a payment, it must make it up before common stockholders receive anything. Noncumulative, or straight, preferred stock does not have this rule. If a dividend is not declared, the payment is simply lost.

Preferred stock also includes several other specific rights and characteristics. Many shares have a fixed liquidation value, also known as par value. This represents the original capital contributed when the shares were first issued. In a liquidation, preferred stockholders have a claim to this par value. This claim is senior to the residual claim of common stockholders. Most preferred shares also have a fixed-dividend amount. This amount is usually a percentage of the par value. Sometimes, dividends are floating. This means they change based on a benchmark interest-rate index like LIBOR.

There are many distinct types of preferred stock in the market. Convertible preferred stock allows holders to exchange their shares for common stock. This is a one-way deal that the investor chooses. Participating preferred stock offers extra dividends if the company reaches specific financial goals. Some shares are perpetual, meaning there is no fixed date to return the capital. Other shares are callable. This gives the corporation the option to redeem the shares before maturity. There is also exchangeable preferred stock, which can be swapped for other securities. Some issues are even "putable," allowing holders to force the issuer to redeem them.

History shows how these instruments have evolved to meet different needs. In 1993, Eli Jacobson created Monthly Income Preferred Stock, or MIPS. He was a tax partner at Sullivan & Cromwell. Goldman Sachs introduced MIPS to the market. It was a combination of debt and preferred stock. MIPS was structured so that payments were interest expenses for the borrower. This allowed the company to deduct the payments from their taxes. At one time, MIPS was very successful. It accounted for over 70% of all new preferred issues. However, MIPS no longer works as a tax shelter today.

Companies use preferred stock for many strategic purposes. It provides an alternative way to fund a business, such as through pension funding. It can also be used as a defense against hostile takeovers. Some companies use "poison pills" to prevent unwanted control changes. They may also use "blank checks." This allows a board of directors to set the terms of new preferred stock later. This can be used to assign high liquidation values or special voting powers. In the United States, there are generally two main categories: straight preferreds and convertible preferreds.

Preferred stock is also vital for how new companies grow. Venture capitalists often provide funding through different rounds. These are labeled as Series A, Series B, or Series C preferred stock. Usually, the founders and employees receive common stock. The investors receive preferred stock with a liquidation preference. This structure helps the company raise large amounts of capital. It also allows employees to have a lower strike price for their stock options. This helps them receive more gains later. By using these different layers, a company can manage its control and its finances at the same time.