There are several ways companies can raise funds to finance upcoming projects, expansion, and other high costs associated with the operation, the most common, including debt and equity issues. Large corporations can choose which kinds of issues they offer to the public, and they base that decision on the type of relationship they want with shareholders, the cost of the issue and the need prompting the financing. When it comes to raising capital, some companies elect to issue preferred stock in addition to common stock or corporate bonds, but the reasons for this strategy vary among corporations.
Preference shares act as a hybrid between common shares and bond issues. As with any produced good or service, corporations issue preferred shares because consumers – investors, in this case – want them. Investors value preference shares for their relative stability and preferred status over common shares for dividends and bankruptcy liquidation. Corporations value them as a way to provide equity financing without diluting voting rights, for their callability and, sometimes, as a means of fending off hostile takeovers.
In most cases, preference shares comprise a small percentage of a corporation’s total equity issues. There are two reasons for this. The first is that preferred shares are confusing to many investors (and some companies), which limits their demand. The second is that stocks and bonds are normally sufficient options for financing.
Why Investors Demand Preference Shares
Most shareholders are attracted to preferred stock because it offers consistent dividend payments without the long maturity dates of bonds or the market fluctuation of common stocks. These dividend payments, however, can be deferred by the company if it falls into a period of tight cash flow or other financial hardship. This feature of preferred stock offers maximum flexibility to the company without the fear of missing a debt dividend payment. With bond issues, a missed payment puts the company at risk of defaulting on an issue, and that could result in forced bankruptcy.
Some preferred shareholders have the right to convert their preferred stock into common stock at a predetermined exchange price. And in the event of bankruptcy, preferred shareholders receive company assets before common shareholders.
Why Corporations Supply Preference Shares
Although preferred stock acts similarly to bond issues, in that it pays a steady dividend and its value does not often fluctuate, it is considered an equity issue. Companies that offer equity in lieu of debt issues can accomplish a lower debt-to-equity ratio and, therefore, gain greater leverage as it relates to future financing needs from new investors.
A company’s debt-to-equity ratio is one of the most common metrics used to analyze the financial stability of a business. The lower this number is, the more attractive the business looks to investors. Additionally, bond issues can be a red flag for potential buyers because the strict schedule of repayments for debt obligations must be adhered to, no matter what a company’s financial circumstances are. Preferred stocks do not follow the same guidelines of debt repayment because they are equity issues.
Corporations also might value preference shares for their call feature. Most, but not all, preferred stock is callable. After a set date, the issuer can call the shares at par value to avoid significant interest rate risk or opportunity cost.
Owners of preference shares also do not have normal voting rights. So a company can issue preferred stock without upsetting controlling balances in the corporate structure.
Although common stock is the most flexible type of investment offered by a company, it gives shareholders more control than some business owners may feel comfortable with. Common stock provides a degree of voting rights to shareholders, allowing them an opportunity to impact crucial managerial decisions. Companies that want to limit the control they give to stockholders while still offering equity positions in their businesses may then turn to preferred stock as an alternative or supplement to common stock. Preferred stockholders do not own voting shares like common stockholders do and, therefore, have less influence on corporate policymaking decisions and board of director selections.
Finally, some preference shares act as “poison pills” in the event of a hostile takeover. This normally takes the form of a detrimental financial adjustment with the stock that can only be exercised when controlling interest changes.