Preferred Stock – Definition

Cite this article as:"Preferred Stock – Definition," in The Business Professor, updated March 31, 2019, last accessed August 8, 2020, https://thebusinessprofessor.com/lesson/preferred-stock-definition/.

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Preferred Stock Definition

Preferred stock is stock in a corporation with preferential rights. All corporations issue common stock as a baseline class of ownership. The company may then issue other classes of stock with rights that differ from those of the common stockholder. This ownership class has a superior claim on the income and assets of the company as compared to common stock.

A Little More on What is Preferred Stock

A preferred stockholder generally has various rights that a common stockholder does not have. Also, the preferred stockholder may not have some of the rights of the common stockholder. Below are some of the common preferences of a preferred shareholder:

Dividends – The preferred shareholder generally gets paid dividends before a common shareholder. Further, she may have guaranteed dividend rights. These dividends may be cumulative (build up each year until a dividend is paid).

Liquidation Rights – The preferred shareholder may be repaid her investment (or a multiple of her investment) before common shareholders receive any money from the sale of the business.

Conversion Rights – The preferred shareholder may be able to convert her shares to common shares if it is more advantageous. It is generally only advantageous when the preferred shares have a cap on the potential value received from the liquidaton or sale of the company.

Information Rights – A preferred shareholder may get special rights to information. This could include the ability to more closely monitor board and executive activity in the company.

Board Seats – Often preferred shareholders are allowed to vote for and elect a specific number of seats on the company board.

Approval Rights – The preferred shareholders may hold the right to approve or block specific company transactions (such as decisions to sell, merge, go public, etc.).

Participation Rights – Preferred shareholders often reserve their rights to participate as investors in subsequent rounds of investment.

Redemption Rights – The preferred shareholder may be able to force the company to redeem or repurchase their shares under certain conditions.

Registration Rights – The preferred shareholder may possess the authority to force a company to register the class of securities with the SEC and/or state regulators for public sale.

This is just a short list of the major rights often afforded a preferred shareholder.

References for Preferred Stock

Academic Research on Preferred Stock

Understanding venture capital structure: a tax explanation for convertible preferred stock, Gilson, R. J., & Schizer, D. M. (2003). Harvard Law Review, 116(3), 874-916. Venture capitalists invest in the preferred stock which is convertible. There are many relevant economic methods, such as convertible stock assigns control based on the success of a portfolio firm. It acts as an indicator to control several types of data asymmetry. It sets the additional payments of businessmen and venture capital traders. This paper is an extension of similar concepts. The authors suggest that using the tax system, subsidies should be provided.

Foreign tax credit limitations and preferred stock issuances, Collins, J. H., & Shackelford, D. A. (1992). Journal of Accounting Research, 103-124.

In this article, the authors elaborate the credit limitations for foreign tax and give details of the rules on the issuance of the preferred stocks.

Preferred Stock–Law and Draftsmanship, Buxbaum, R. M. (1954). Calif. L. Rev., 42, 243. This research evaluates voting rights for specific offered activities and on default in the payment of dividend. For example, the basic source of legal rights of a share, participation right in dividends not within the scope of a stated preference, the privilege of redemption, liquidity preference and conversion mechanics.

The effect of issuing preferred stock on common and preferred stockholder wealth, Linn, S. C., & Pinegar, J. M. (1988). Journal of Financial Economics, 22(1), 155-184. Normally, the issuance of preferred stock by utilities is at a fixed rate. The issuance by industrial concerns is at a fixed rate that is convertible. The issuance by financial institutions is at a rate which is adjustable. The abnormal returns of common shares are economically ineffective for utilities, effective at the level of 0.05 and negative for the industrial concerns and effective and positive at the level of 0.10 for the financial institutions. Returns to the preferred stockholders neither favour hypotheses of price-pressure nor the wealth redistribution.

Venture capital on the downside: preferred stock and corporate control, Bratton, W. W. (2002). Michigan Law Review, 100(5), 891-945. This study evaluates the downside arrangements in the agreements of venture equity. Its protection means the power to change the managers of the company and/or power to secure the venture agreement itself from any kind of opportunistic alteration. When debates between the entrepreneurs and the venture capitalists are presented in the court, an assumption supporting the common stockholders cannot be defended on the effective grounds.

Financing with preferred stock, Houston Jr, A. L., & Houston, C. O. (1990). Financial Management, 42-54. On the market supply-side for the preferred stock, the behaviour of an industry is investigated. In 1980, many variations were found. This paper demonstrates that financial institutions and industrial concerns dominated the preferred stock market from 1981 to 1987. This was not the case with the utilities. The authors strongly favour the preferred stock tax hypothesis. The issuer companies of the preferred stock have fairly large tax rates.

A theoretical model for valuing preferred stock, Emanuel, D. (1983). The Journal of Finance, 38(4), 1133-1155. This research presents a method of preferred stock value that consists of a chance of dividends on it being omitted. The analytical structure depends on the option-hedging model developed by Black and Scholes. Brief valuation formula is presented for preferred stock which can be cumulative or non-cumulative. The values got from this formula largely differ from those on the basis of risk-oriented perpetual bonds.

 

Non-cumulative preferred stock, Berle, A. A. (1923). Columbia Law Review, 23(4), 358-367. This paper covers the topic of preferred stock which is non-cumulative. Its benefits and drawbacks have been highlighted.

The effect of preferred stock rating changes on preferred and common stock prices, Stickel, S. E. (1986). Journal of Accounting and Economics, 8(3), 197-215. To check the impact of the preferred stock rating variation announcements, daily returns are utilized. It occurs after the announcement day, on one more event day, most often. Big returns are linked to the announcements that the confounding events make foul. But abnormal returns acts as the yield of these events appear more as compared to the variation in rating.

Dutch auction rate preferred stock, Alderson, M. J., Brown, K. C., & Lummer, S. L. (1987). Financial Management, 68-73. The cash managers of big companies have devised many strategies based on the equity in order to use the exclusion of partial tax for dividend revenue. It requires protection of the principal investment. This research evaluates the latest innovation known as DARPS, i.e. Dutch Auction Rate Preferred Stock. The findings are that the issuance of DARPS gives a higher return of after-tax. Profits show that the issuing and buying companies share the tax advantages of the exclusive dividend.

The usefulness of hybrid security classifications: Evidence from Redeemable preferred stock, Kimmel, P., & Warfield, T. D. (1995). Accounting Review, 151-167. This paper provides statistical proofs on hybrid security using the relationship of procedural risk and the company’s leverage, known as RPFD (Redeemable Preferred Stock). The authors perform a test to examine the changes in this relationship. They conclude that it might be hard to devise a brief classification principle for hybrid securities. For this, there is no need to disclose the vital security attributes.

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