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Common Stock vs Preferred Stock: How They Differ

Understanding Common Stock and Preferred Stock, the various types, their similarities and differences

Common Stock vs Preferred Stock: How They Differ

Understanding Common Stock

Common stocks are regular equities that have been sold to the general public in order to provide a source of finance for corporate growth.

To issue common stocks, a privately held business must go public. They must therefore carry out an initial public offering (IPO) in order to go public and register with a legitimate stock exchange.

Let's examine common stock in detail.

Initial Public Offering (IPO)

To illustrate the IPO Process, we shall use an example.

To sell the first share of the company to the general public, an IPO is required.

  • Steve owns a company in the city. He trades in vintage classics. He serves many people in this area and has a sizable clientele.
  • Steve's pals advise him to take risks. He ought to start selling copies of his older famous works so that he can reach a wider audience.
  • Steve thinks the concept is fantastic. He lacks the funds, though, to open stores in many cities. He then seeks assistance from an investment bank.
  • The investment bank advises Steve to pursue an initial public offering (IPO). Steve thinks that's a fantastic plan. So he makes a request to the bank.
  • The investment bank conducts a business valuation at Steve's bookstore. They discover that the bookstore is worth more than $500,000. They, therefore, urge Steve to purchase 50,000 shares at a price of $10 apiece.
  • Steve makes the decision to keep 50% of his shares and sell the other 50%. At a price of $10 per share, he sells all 25,000 of his shares, netting him almost $250,000.
  • He has now made the decision to open new businesses in three more cities using this money.

It's how the IPO procedure functions. And it's ideal for businesses that don't want to take out long-term loans.

Rights of Common Stockholders

The owner's finances are compared to common stocks. If you are one of the company's regular shareholders, you are the business's owner.

And common investors are important to business theory as a whole. The goal of the entire company is to increase shareholder value. Therefore, common investors are essential to a company's ability to survive and grow.

These are the common stockholders' rights:

  • Voting rights: They are able to cast critical votes on matters that the company is currently grappling with. In spite of receiving the dividend before regular stockholders, preferred shareholders are not permitted to vote, making it a key right.
  • Right to receive dividends: Possess the right to dividends in the event that the business is profitable. Typically, when a business first starts out, the dividend is not paid to the shareholders. The entire sum is invested back into the company. After receiving approval from the board of directors, it is done. A set percentage of the company's profits is later distributed as dividends to the owners of common stock when the company's core has been strengthened. But only after the corporation has repaid all outstanding loans and distributed the preferred stockholder dividend.
  • Right to sell off the stocks for profits: Common stockholders, also known as equity shareholders, have the right to sell their shares for a profit to other parties. Equity stockholders can sell their shares to someone who is interested in buying the shares of that specific company at a greater price since common stocks cannot be redeemed. They can make enormous profits and fast become affluent thanks to this right.
  • Right to receive the remaining cash after liquidation: Equity shareholders have the right to receive any remaining funds following a company's liquidation, depending on the percentage of shares they possess. The only problem is that all liabilities must first be settled following liquidation. The preferred stockholders are then compensated. The remainder, if any, is subsequently given to the common stockholders in proportion to their shareholding if any sum is left over.

Shareholders’ Equity Statement

The corporation keeps a financial statement to reflect the common stock and preferred shares (if any).

One of the four most significant financial statements that every investor should review is the shareholders' equity statement.

Let's examine the shareholders' equity statement's format.

Types of Common Stock

Since each common share is typically equal to every other common share, common shares are more vulnerable to dilution if the issuing business were to raise more funds.

The classification of shares, however, is one of the few true variations seen across common shares (and the number of votes carried by each class).

Understanding Preferred Stock

The extension of common stocks and preferred stocks provides preferred owners a priority in the dividend distribution.

For instance, the dividend payment is fixed if a corporation issues preferred shares. The rate is typically higher than the common stockholders' dividend payout ratio.

The dividend payout for common stockholders will rise in a successful business, but since it is fixed, the payout for preferred stockholders won't change.

It is a mix of common stock and a bond, to put it simply:

  • Preference share owners are eligible to earn dividends just like common stockholders. However, the sole distinction is that when offering dividends, preference will be given to shareholders.
  • A set rate of dividend payout is also available to anyone who possesses preference shares. This means that if a loss is realized by the business, the preferred shareholders must get a dividend. Additionally, the preferred shareholders must receive dividends from the company's profits. And one of a bond's fundamental qualities is this.

Rights of Preferred Stockholders

  • Ownership rights: By purchasing preferred stocks through brokers, preferred stockholders can potentially acquire ownership rights in the business.
  • The right to receive preferential treatment when paying out dividends is the main benefit of preferred stock ownership. Common stockholders do not receive the dividend until preferred stockholders do. Additionally, preferred stockholders are entitled to a dividend when the business is not profitable.
  • Right to receive a fixed dividend: Preferred stockholders receive a fixed dividend rate at the time the preference shares are issued. Currently, it lies between 5% and 7%. Preferred investors receive a guaranteed 5%–7% payout regardless of the company's financial performance, making them an attractive option for those who are not very adventurous or risk-averse. Similar to that, it also has a drawback. The dividend payout rate is fixed, so even if the business experiences tremendous success, preferred stockholders won't receive additional dividends. Holding common shares appears to be more advantageous in this situation.
  • Possession of the right to get preferential treatment during liquidation: Even in the event of a business liquidation, preferred investors are given the first option to receive dividend payments. However, because the business must first settle its liabilities, they are not paid first. However, they receive payment before common investors. Common investors can end up with nothing since the proceeds from the liquidation run out after paying off the debts and dividends owed to preferred stockholders.
  • Right to get back payments: If a corporation fails to pay its preferred shareholders in a given year for a certain cause, it is required to make up the difference the next year. It is a unique privilege available solely to preferred stockholders. Common investors are not granted this privilege. If the arrears are not paid in a year, they are not paid the next year.

Types of Preferred Stock

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

The returns from preferred securities can mirror bonds in terms of the following, depending on how the preferred shares are structured:

  • Fixed Payments: Received as dividends rather than interest.
  • Par Value: Variable depending on the state of the market; if interest rates were to rise, the preferred shares' value would decrease (and vice versa)

Preferred shares are typically provided to angel investors, early-stage venture capital firms, or other institutional investors in private companies that want to maintain their current ownership stake (i.e., anti-dilution rights).

These preferred share issuances are typically designed with different safeguards to reduce risk in the event of a downturn.

Similarities – Common Stock vs. Preferred Stock

Companies issue equity to attract outside capital, and if the issuer is publicly listed, these ownership interests can be exchanged between institutional and ordinary investors on the open market.

As common shares and preferred shares are equity instruments, both shareholder groups have a claim to the company's future profits.

The following sources provide possible returns on investing in common shares:

  • Capital Gains: Selling shares for more money than you paid when you bought them results in capital gains (i.e., share price appreciation)
  • Dividends: Direct cash payments from retained earnings to common shareholders

Despite the trading prices of preferred shares typically being less volatile in comparison, these two factors also contribute to the returns from preferred shares.

In addition, the company's retained earnings (i.e., total net income) must be used to pay common and preferred dividends, which brings us to our next issue.

The two classes of shareholders who are last in line to get a portion of a company's remaining "bottom-line" profits are common and preferred stockholders.

Equity holders are not entitled to any proceeds until all other debt lenders and claims with higher seniority have been fully paid; for instance:

  • Companies that have interest payments owing on their outstanding debt are unable to release dividends until all debt-related obligations have been satisfied.
  • Equity holders are the two stakeholder groups that are prioritized last when corporations declare bankruptcy (and usually receive no proceeds).

Differences – Common Stock vs. Preferred Stock

  • The primary distinction is that common stockholders don't get their dividends until preferred stockholders do.
  • The dividend is not paid to common stockholders at a set pace. Preferred stockholders receive the dividend at a predetermined rate.
  • Common stockholders grow with the company. Therefore, common stockholders have enormous growth potential. On the other hand, the preferred stockholders’ growth potential is fixed.
  • Common stockholders have voting rights and can vote on the critical issues of the company. Preference stockholders don’t have any voting rights.
  • After liquidation, the preferred investors are compensated before the common stockholders.
  • The arrears do not accumulate in the following year if the common stockholders are not paid in full for a given year. In the case of preferred shareholders, the arrears accrue, and the company has to pay the arrears in the next year.
  • Prior to paying common stockholders, preferred stockholders are paid.
  • In the event that the common stockholders are not paid in a given year, the arrears do not accumulate in the following year. In the case of preferred shareholders, the arrears accrue, and the company has to pay the arrears in the next year.

Comparative Table

Trading with Common Stock and Preferred Stock

Investors who want to buy common or preferred stock will probably do so through a broker. Most online brokers have cut trading commissions to zero, so you won’t have to worry about the high costs to place an order. Trading costs will probably be higher if you use a conventional broker.

You can place a trade order for the number of shares you want to buy once you've determined which security you're interested in purchasing. Not all companies offer preferred stock, so be sure to check what’s available through your broker.

Exits (IPOs) and Bankruptcies

With the exception of unusual circumstances, preferred shares are automatically converted into common shares once a company is about to exit by going public or being sold (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:

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

However, while these protective measures may have a favorable effect on venture investing returns to investors, the advantages of preferred shares are reduced in bankruptcy situations.

How do stock classes work?

In most cases, there is only one class of stock when a company issues common stock. However, in some situations, firms may issue various share classes, generally named Class A, Class B, and Class C shares, for example

Traditionally, Class A shares are publicly traded and come with one vote, just like any other type of common stock. Class B shares, on the other hand, may exclusively be available to firm owners and executives. In addition, they may have greater voting power than a single vote per share. Lastly, Class C shares tend to be much like Class A shares, but traditionally they have no voting rights.

Preferred stock can have different classes, too. In the case of preferred stock, various classes have distinct priorities in terms of dividends and a payout in liquidation. But these classes still have priority over common shares. Like bonds, each series of preferred stock has its own dividend, call date, and other terms.

What’s the verdict?

The answers would be different for different sets of people. Common stocks may be a good choice if you enjoy taking risks and seeing your money grow by a factor of two, three, or four.

Owning common stocks will give you a lot of growth potential, but you won’t enjoy a fixed dividend. But you'll develop alongside the business.

On the other hand, if you don’t want to take much risk and want to enjoy a decent dividend pay-out, you should go for preferred stocks.

The idea is to see how tolerant and patient you’re in your investment journey. If you can afford to accept additional risks, common stocks would be your best option. However, if you have a risk-averse mindset, you should purchase preferred stocks from brokers.

There is therefore no right or wrong response to this. You’re the best judge of what you should purchase and why.


What happens when you convert preferred stock to common stock?

When holders of convertible preferred stock want to convert their shares into common shares, they are given freshly issued shares in exchange. The total number of common shares rises as a result. The value of current shares decreases because there are more common shares issued even though the company's worth stays the same.

What is the safest form of stock common or preferred?

Bonds: For an investor, purchasing bonds from a publicly traded corporation is often the safest option. Legally, dividends on the preferred or common stock must be paid after bond interest payments.

Can common stock be diluted?

Shares may be diluted via conversion by owners of optionable securities, secondary offerings to obtain extra funds or the issuance of new shares in consideration for purchases or services.

Why is common stock riskier than preferred stock?

If a corporation issues common stock, the holders will not get paid until the bondholders, preferred shareholders, and debtors have all gotten their shares, respectively. Due to this, common stock is more dangerous than debt or preferred stock.

How many shares can a company issue?

How many shares is a firm allowed to have? When there is only one owner of the entire firm, the minimum number of shares that can be issued by the corporation is one. There is no set limit on the number of shares a corporation can issue, therefore this can vary from business to business.