Preferred stock

Definition

Preferred stock is a class of ownership in a corporation that has a higher claim on assets and earnings than common stock. Holders of preferred stock typically receive dividends before common shareholders and have priority in the event of liquidation, but they usually do not have voting rights. This type of stock is crucial in stock acquisitions as it can affect the overall valuation of a company and influence investor decisions.

5 Must Know Facts For Your Next Test

1. Preferred stock dividends are often fixed and can be cumulative, meaning any unpaid dividends must be paid out before common dividends.
2. Preferred shareholders usually have a claim on assets in the event of liquidation, ranking above common shareholders but below debt holders.
3. Unlike common stockholders, preferred stockholders generally do not have voting rights, limiting their influence over corporate governance.
4. Preferred stock can be convertible, allowing shareholders to convert their shares into common stock under certain conditions, providing flexibility for investors.
5. In mergers and acquisitions, the presence of preferred stock can complicate negotiations and valuations due to its preferential treatment over common shares.

Review Questions

• How does the presence of preferred stock influence the valuation of a company during a stock acquisition?
  • The presence of preferred stock can significantly influence a company's valuation during a stock acquisition because it establishes a hierarchy among equity holders. Preferred shareholders have priority over common shareholders when it comes to dividend payments and asset distribution during liquidation. This preferential treatment can make preferred shares more attractive to investors, affecting the overall price investors are willing to pay for the company's equity. As such, companies with substantial preferred stock may be valued lower or higher depending on the perceived risk and benefits associated with these shares.
• Discuss the differences between preferred and common stockholders in terms of their rights and claims during liquidation.
  • Preferred stockholders have preferential rights over common stockholders regarding claims on assets during liquidation. In the event that a company is liquidated, preferred shareholders are paid first before any distributions are made to common shareholders. Additionally, while preferred shareholders typically receive fixed dividends and may have cumulative rights for unpaid dividends, common shareholders only receive dividends if declared by the board and have no guaranteed payments. This lack of priority for common stockholders underscores the higher risk they assume compared to preferred investors.
• Evaluate how preferred stock affects corporate governance and decision-making in comparison to common stock.
  • Preferred stock's impact on corporate governance and decision-making is notable primarily due to its lack of voting rights. Preferred shareholders typically do not participate in key corporate decisions, which are reserved for common shareholders who hold voting power. This means that while preferred investors may secure financial returns through dividends and liquidation preferences, they often lack influence over the strategic direction of the company. Consequently, management may prioritize the interests of common shareholders when making decisions, which could lead to conflicts if the financial stability desired by preferred shareholders does not align with growth-oriented strategies favored by common equity holders.

Related terms

Common Stock:

Common stock represents ownership in a corporation and typically comes with voting rights, allowing shareholders to participate in corporate decisions.

Dividend: A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits, which can be paid in cash or additional shares.

Liquidation Preference: Liquidation preference refers to the order in which different classes of stockholders receive payment in the event that a company is liquidated, with preferred stockholders typically being paid before common stockholders.