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What is Preferred Stock?

There are two types of shares that you can invest in: common stock and preferred stock. These types of stock differ in price, perks and power. It’s important to understand the difference between common and preferred stock so that you know exactly what you’re getting out of your investment.

Preferred stock definition

Preferred stock, also known as preference shares, are shares in a company that are given priority over common stocks when it comes to dividend payments. While bonds are prioritized over preferred stock, shareholders of preferred stock are always paid dividends before common stock dividends are paid out. Typically, preferred stocks have a fixed dividend, unlike common stocks.

While common stock shareholders have voting rights within the organization, this right is generally not afforded to holders of preferred stock. Common shareholders are usually entitled to one vote per share owned. Shareholder votes are used for corporate policies and business decisions, meaning having the power to vote gives you some influence in the direction of the company.

Preferred shareholders forgo voting power in lieu of fixed, prioritized dividends. Generally, preferred stocks are more expensive than common stocks.

Types of preferred stock

There are four different categories of preferred stock: cumulative preferred stock, non-cumulative preferred stock, participating preferred stock, and convertible preferred stock.

Cumulative preferred stock

Cumulative preferred stock owners are entitled to dividend payments that were omitted in the past, before common dividends are issued. This means that any dividends not paid in prior periods since the investment was made will be paid retroactively. 

Dividends are declared and paid on a periodic basis, at the discretion of the organization. If a dividend is not declared for a certain period, preferred shareholders are still entitled to that dividend, and any unpaid dividends will accumulate until the next payment is made.

Non-cumulative preferred stock

Non-cumulative preferred stock holders are not entitled to retroactive dividend payments, but otherwise have the same conditions as cumulative preferred stock. If the company skips dividend payments over a certain period, non-cumulative preferred shareholders cannot claim any payment.

Participating preferred stock

In addition to being issued the general dividend for preference shares, owners of participating preferred stock are entitled to additional dividends based on predetermined conditions. These conditions will generally be certain performance targets or benchmarks the organization hopes to reach, such as extraordinarily high profits.

Should the organization be liquidated, participating preferred shareholders may have the right to be paid back the initial purchase price of the stock in addition to a pro-rata share of any remaining proceeds distributed to common shareholders. 

Convertible preferred stock

Convertible preferred stock can be converted from preferred shares into common shares. This typically occurs at the request of the shareholder, although there are some cases where the organization itself is able to convert preferred shares into common shares.

Liquidation with preference shares

In the event that an organization you own preferred shares in goes bankrupt, preference shareholders are always paid before common shareholders. Preference shareholders are still of lower priority than corporate bonds and debentures, but in the case of bankruptcy, they will have a claim to a share of the company’s assets before common shareholders do.

Preferred stock vs. common stock

The shares you choose to invest in will depend on what you wish to get out of your investment. If you’re focused solely on financial gain and you’re investing in an organization that has a history of paying substantial dividends, you should certainly consider preferred shares.

On the other hand, if you’re investing in a business that you’re passionate about and you want to have a say in the direction of the organization, then you’ll want to go for common shares, with which you retain voting rights. 

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