Preferred Shares vs. Common Shares

Introduction to Preferred Shares vs. Common Shares

Companies issue equity financing to raise capital from outside investors, and if the issuer is public, these ownership interests can be traded among institutional and retail investors in the open market.

Common shares and preferred shares are equity instruments – this means that both shareholder groups are entitled to the future profits of the company.

The potential profits from investing in common shares come from:

1. Capital Gains: Selling shares at a higher price than the price paid on the date of purchase (i.e., share price appreciation)
2. Dividends: Cash payments made directly to common shareholders from retained earnings

These two factors are also contributors to the returns from preferred shares, although the trading prices of preferred shares tend to be less volatile in comparison.

Additionally, common and preferred dividends must be paid from the retained earnings of the company (i.e., the accumulated net income), which leads to our next point.

Common and preferred stockholders represent the two groups that are last in line to share in the residual “bottom-line” profits of a company.

Equity holders are not entitled to receive any proceeds unless all other debt lenders and higher seniority claims are paid in full – for example:

• Companies with interest payments coming due on their debt outstanding cannot issue any dividends until all the obligations related to their debt are paid off
• When companies file for bankruptcy, equity holders are the two stakeholder groups last in line in terms of priority (and usually receive no proceeds)

Preferred Shares vs. Common Shares: What is the Difference?

Common and preferred shareholders are both are the bottom of the capital structure, but preferred shareholders hold higher priority as the 2nd lowest tier claim.

The primary drawback to common shares is being the security with the lowest seniority, which directly impacts the required returns.

Even if a company performs well fundamentally, the market sets the share price at the end of the day, which can often be influenced by irrational investor sentiment.

The amount of uncertainty surrounding the share price movement, coupled with being the lowest seniority security in the capital structure, is one of the reasons why the cost of equity (i.e., the required rate of return to invest) is higher for common shares.

The price of common shares tends to be less reliable due to the unpredictable factors that could impact the market’s perception of a particular company (and the share price).

Common shares have the most upside potential from higher profits, which also means the securities come with the most downside risk (i.e., “double-edged sword”).

Unlike other types of financing instruments such as fixed income, the upside of common equity is theoretically unlimited and not capped.

Moving onto the topic of dividends for common shareholders, the decision to pay out a periodic dividend (and the dollar amount) is a discretionary choice up to management, which is often a result of:

1. Consistency in Profits
2. Stabilization in Share Price
3. Mature Industry with Low Disruption-Risk

Common shareholders are never legally guaranteed any dividends, but some come to expect payouts based on historical patterns.

Once a company starts paying dividends, they tend to continue to pay them since if they cut them, it typically sends a negative signal to investors.

In comparison, preferred shares come with a pre-determined dividend rate – in which the proceeds can either be paid in cash or paid-in-kind (“PIK”), which means that the dividends increase the value of the principal rather than being paid out in cash.

Similar to fixed-income bonds, preferred shares often come with a guaranteed dividend (or at least the guarantee of preferential treatment ahead of common shareholders).

Legally, preferred shareholders could be paid a dividend whereas common equity holders are issued nothing. However, this cannot occur the other way around (i.e., common shareholders cannot be paid a dividend if preferred shareholders were not).

Because of the bond-like features of preferred shares, the trading prices deviate to a lesser degree following positive/negative events such as outperformance on an earnings report.

Preferred shares are comparatively more stable investments due to their fixed dividends, although they have less profit potential.

In addition, the two sources of returns (share price and dividends) are closely interlinked, but in contrasting directions:

1. The issuers of dividends tend to be mature, low-growth companies with share prices that are unlikely to change much
2. High-growth companies with significant share price upside potential are far more likely to reinvest in growth or perform share buy-backs

For so-called “cash cows” (i.e. mature businesses), profits are expected to remain high and steady, but the growth opportunities in the market have become scarce — hence, the company decides to distribute cash to common shareholders as opposed to re-investing it for growth.

Of course, there are exceptions to this rule, like Visa (NYSE: V), which is a stable market leader with high growth that issues dividends, but Visa is part of the minority, not the majority.

Another distinction is that preferred shares do not carry voting rights like common shares.

During shareholder meetings, votes on important corporate policy decisions take place, such as the election of the board of directors. Preferred shareholders cannot participate in these votes and thereby have minimal say in such matters.

Classifications of Common Shares

Common shares are more prone to dilution if the issuing company were to raise more funding, as each share is typically identical to any other common share.

However, one of the few actual differences found among common shares is the classification of shares (and the number of votes carried by each class).

Snapchat IPO: Non-Voting Shares Example

A highly anticipated initial public offering (IPO) that consisted of no-vote common shares was the IPO of Snap Inc. (NYSE: SNAP) in 2017.

While structuring common shares with different voting rights is common practice for IPOs, the no-vote common shares were a rarity and met with much criticism.

The majority of shareholders were not given voting rights in Snap’s IPO, which was controversial since key decisions were basically entirely up to management under the proposed corporate governance plan.

Even Snap’s S-1 filing acknowledged that “to our knowledge, no other company has completed an initial public offering of non-voting stock on a US stock exchange” and possible negative implications on the share price and investor interest.

In Snap’s IPO, there were three classes of stock: Class A, Class B, and Class C.

• Class A: Shares traded on the NYSE with no voting rights
• Class B: Shares for early investors and executives of the company and come with one vote each
• Class C: Shares held only by Snap’s two co-founders, CEO Evan Spiegel and CTO Bobby Murphy – each Class C share would come with ten votes apiece, and the two holders would have a combined 88.5% of Snap’s total voting power post-IPO

^{Snapchat Class of Shares (Source: Snap S-1)}

Types of Preferred Shares

Compared to common shares, there are considerably more variations of preferred shares:

Depending on how the preferred shares are structured, the returns from preferred securities can resemble bonds in terms of the:

• Fixed Payments: Received in the form of dividends, as opposed to interest
• Par Value: Varies based on current market conditions – if interest rates were to rise, the value of the preferred shares would decline (and vice versa)

For private companies, preferred shares are most often issued to angel investors, early-stage venture capital firms, or other institutional investors that seek to protect their existing ownership percentage (i.e., anti-dilution rights).

These issuances of preferred shares normally come structured with various protective provisions that help limit downside risk.

Initial Public Offering (IPO) Exits and Corporate Bankruptcies

Once a company is on the verge of exiting by going public or being sold, the preferred shares are converted into common shares on the investors’ accord and/or automatically – barring atypical circumstances (e.g., pre-negotiated conversion into different classes of common shares).

Although in a bankruptcy scenario, common and preferred equity are typically “wiped out”, the benefits of preferred shares become more apparent when it comes to:

1. Capital Raising
2. Liquidity Events (e.g., Sale to Strategic or Financial Buyer)

But while these protective measures can have positive impacts on the returns to investors in venture investing, the benefits of preferred shares diminish in bankruptcy scenarios.