Preferred Stock vs Common Stock: Understanding Stock Ownership Options
Written By:
Team Qapita
July 12, 2024
As a startup founder, you are always looking for methods to grow and scale your business. This typically requires extra capital, which you can obtain from different sources like personal savings, loans, venture capital, or issuing shares.
Stock issuance is a standard method used by startups to raise funds. When a company issues stock, it offers a part of its ownership to investors in exchange for capital. This stock can be classified into two main types: preferred stock and common stock. Each type of stock comes with its own set of rights, benefits, and drawbacks.
The choice between issuing preferred stock vs common stock can have significant implications for your startup's financial health and control over the company. This blog offers a detailed explanation of both types of stock, their advantages and disadvantages, tax implications, and their key differences.
What is Preferred Stock?
Preferred stock is a type of equity security which shares features of both an equity and a debt instrument. It's generally viewed as a higher-ranking security compared to common stock. Preferred shareholders get preferential treatment over common shareholders on the company's assets and earnings.
This means that in the case of bankruptcy, they are paid out before common stockholders. Preferred stock can be an attractive choice for investors and venture capitalists who want the potential for profit through dividends but also want more security than common stock. Issuing preferred stock can also be an excellent method for your company to raise capital without taking on debt or diluting the voting power of existing shareholders.
Rights and Responsibilities of Preferred Stockholders
Here are the rights and responsibilities that come with preferred stock:
Dividend Preferences: Preferred stockholders often receive dividends at a fixed rate before common stockholders. This can act as a steady source of income for the stockholders.
Liquidation Preferences: In the unfortunate event of company liquidation, preferred stockholders have a priority claim over any remaining company assets. This can be a significant risk mitigation factor for investors, as it provides a layer of protection if the company is facing financial distress.
Voting Rights Limitations: Preferred stockholders typically do not have the same voting rights as common stockholders. This means they have less influence over company decisions, such as electing the board of directors or approving significant corporate actions like mergers and acquisitions.
Other Responsibilities: Preferred stockholders also have other responsibilities, such as adhering to company policies and participating in certain corporate actions like convertible note agreements or debt financing rounds.
Benefits and Challenges of Preferred Stock
Benefits of Preferred Stock
Participating Shares: Also referred to as participating preferred shares, these securities offer extra dividends to the holder, over and above the fixed rate, if the company achieves specified profit goals. This can provide preferred stockholders with a higher return on their investment as the dividend calculations here are done using a different formula.
Anti-Dilution Protection: Some preferred stocks come with anti-dilution protection. It shields stockholders from ownership stake erosion (dilution) caused by future funding rounds. Dilution can occur during 'down rounds' where the company's value dips or even in successful fundraising that expands the total number of shares. This protection helps ensure the initial investment value remains relatively stable.
Interest Rate Sensitivity: If interest rates rise, preferred stock dividends can seem less attractive. This interest rate risk could cause buyer's remorse among preferred stock investors, who might feel that they would have fared better with higher-interest fixed-income securities.
Limited Growth Potential: While these stocks offer steady income through fixed dividends, they typically have lower capital appreciation potential compared to common stocks. This means that the price of the stock may not increase significantly over time, which might not appeal to growth-focused investors.
Tax Implications of Preferred Stock
Here are the tax implications of preferred stock that impact investors as well as the founders:
Dividend Taxation
Dividends received from preferred stocks are subject to taxation. However, the tax treatment depends on whether the dividends are classified as 'qualified' or 'non-qualified'. Qualified dividends are taxed at a rate lower than regular income.
The tax rate for qualified dividends can be anywhere from 0% to 20%, based on the individual's taxable income as per the current IRS guidelines. Non-qualified dividends, however, are taxed at the higher rates of 10% to 37%, which are applicable to ordinary income.
Capital Gains
When an investor sells preferred stocks for a profit, these earnings are known as capital gains and are subject to capital gains tax. If the shares were held for over a year before being sold, the profits are taxable at a long-term capital gains rate, ranging between 0% to 20%. If the shares were held for a year or less, the profits would be taxed at the regular tax rate, which could go up to 37%.
Tax Advantages and Disadvantages
The opportunity to enjoy lower tax rates on qualified dividends makes preferred stocks a better investment option for investors. However, preferred shares do not offer your company a direct tax benefit, as the dividends are paid out of after-tax profits.
As discussed earlier, if interest rates rise, the relative attractiveness of your preferred stock can diminish. Investors may find other investments, like bonds with higher interest rates, more appealing. This can result in a decrease in the price of your preferred stock, potentially resulting in capital losses if you sell.
Understanding Common Stock
Common stock is the most common class of shares issued by companies. Common stockholders are part-owners of the company, have the right to vote on major company decisions, and may also receive dividends. However, they will be the last group to receive any remaining assets if the company faces liquidation.
Each common share typically grants one vote to the holder for electing board members who make crucial decisions about the management issues and corporate direction of your company. This translates to a stronger influence on corporate policy and leadership compared to preferred stockholders. Common stock offers excellent potential for higher long-term returns compared to preferred shares because when your company thrives, the value of common shares can rise significantly.
Rights and Responsibilities of Common Stockholders
Here are the rights and responsibilities accompanying common stock:
Voting Rights: One of the key rights granted by common stockholders is voting rights. They have the right to vote on all important corporate decisions, like mergers and acquisitions or the election of the board of directors. This means they can make an impact on the future direction of your company.
Dividend Entitlements: Common stockholders are also entitled to dividends. However, unlike preferred stock, these dividends are often variable and not guaranteed. The board of directors may decide to reinvest profits back into the company rather than distribute them as dividends. This can be a problem for investors who want steady income, but it can also lead to capital growth if the reinvested profits increase the company's value.
Residual Claim: Common stockholders have a residual claim on your company's assets and earnings. This means that after all obligations to creditors and preferred stockholders have been met, common stockholders are entitled to the remaining assets. While this can be beneficial if your company is successful, it also means that common stockholders bear additional risks in case of failure.
Benefits and Challenges of Common Stock
Benefits of Common Stock
Limited Liability: When investors purchase common stock in a company, their assets are not at risk if the company faces legal trouble. The extent of their liability is limited to the amount they have invested in the company. This offers a safety net for investors, protecting them from potential financial losses beyond their investment.
Ease of Trading: Common stocks enjoy high liquidity and can be easily traded on any online trading platform. This ease of trading makes common stock a flexible investment option, allowing investors to adjust their portfolios as needed.
Challenges of Common Stock
Market Fluctuations: Market fluctuations can significantly affect the value of common stocks. This means that the share price can rise or fall rapidly over a short period, leading to substantial investment losses.
Multiple Stock Classes: Some companies issue multiple classes of common stock, such as Class A, Class B, or Class C shares. Each class of shares may have different rights in terms of voting and dividend payments, which can complicate the investment decision.
Tax Implications of Common Stock
Here is an overview of the major tax implications of common stock:
Dividend Taxation
The tax treatment of dividends received from common stocks depends on their classification as 'qualified' or 'non-qualified'. You must note that qualified dividends are taxed at a lower rate than ordinary income. The tax rate on qualified dividends varies between 0% and 20%, depending on the filing brackets for different individuals. Non-qualified dividends, on the other hand, are taxable at higher rates of up to 37% based on the filing status.
Capital Gains
When common stocks are sold for a profit, these earnings are known as capital gains and are subject to capital gains tax. If investors have held common shares for over a year before being liquidated, the profits are taxable at the long term capital gains rate ranging between 0% to 20%. If investors have held the shares for a year or less, the profits will be taxed at an ordinary tax rate of up to 37%.
Tax Strategies
There are several tax strategies that common stockholders can employ to optimize their tax outcomes. One such strategy is tax-loss harvesting; it involves selling stocks that have experienced a loss to offset the capital gains tax liability. Another strategy is to hold onto the stocks for at least a year before selling them to enjoy the long-term capital gains rate, which is lower than the standard tax rates.
Preferred Stock vs Common Stock: Comparative Analysis
Here is a comparative analysis of preferred stock vs common stock along some vital parameters:
Dividends
Preferred Stock: Preferred stockholders receive fixed dividends, which are typically higher and more stable compared to common stock dividends. These dividends are paid out before any dividends are given to common stockholders.
Common Stock: Common stockholders receive variable dividends, which can fluctuate based on the company's profitability. The main difference here is that dividends are not guaranteed and are often lower than those of preferred stock.
Voting Rights
Preferred Stock: Preferred stockholders generally do not have voting rights, meaning they have little to no influence on company decisions and board elections.
Common Stock: Common stockholders typically have voting rights, which allow them to take part in important corporate decisions, such as approving amendments to the corporate charter or voting on matters that could affect the company's operational direction.
Risk
Preferred Stock: Preferred stock is generally less risky than common stock due to its fixed dividends and higher claim on assets during liquidation.
Common Stock: Common stock is considered riskier due to its variable dividends and lower priority in asset claims during liquidation.
Priority in Liquidation
Preferred Stock: In the event of liquidation, preferred stockholders enjoy a higher priority claim on the company's assets than common stockholders but lower than debt holders.
Common Stock: Common stockholders have the lowest priority in asset claims during liquidation, receiving any residual assets only after debt holders and preferred stockholders have been paid.
Conversion and Callability
Preferred Stock: Some preferred stocks are convertible into a specified number of common shares, providing higher potential upside. Additionally, preferred stocks may be callable, meaning the issuing company can repurchase them at a predetermined stock price.
Common Stock: Common stocks do not have conversion or callability features, meaning they remain as common equity unless sold or bought back by the company under market conditions.
Deciding between Preferred or Common Stock
Choosing between preferred and common stock would depend on investors' investment goals, risk tolerance, and portfolio strategy. Here are some factors to consider while making the choice:
Investment Goals
Preferred Stock: If the goal is to generate a steady income stream, preferred stock might be the better choice. With its fixed dividends, preferred stock can provide regular income, making it a suitable option for income-focused investors.
Common Stock: If the goal is capital appreciation, common stock could be more appealing. The potential for price appreciation and variable dividends can offer higher returns, especially for growth-oriented investors.
Risk Tolerance
Preferred Stock: Preferred stock is generally less risky than common stock. If an investor has a low-risk tolerance, the fixed dividends and higher claims on assets during liquidation offered by preferred stock can provide a sense of security.
Common Stock: Common stock is riskier due to its variable dividends and lower priority in asset claims during liquidation. If an investor enjoys a higher risk tolerance and is willing to accept potential losses for the chance of higher returns, common stock might be a suitable choice.
Portfolio Strategy
Preferred Stock: Preferred stock can be a good addition to a diversified portfolio, providing a balance between bonds and common stocks.
Common Stock: Common stock can offer diversification benefits and the potential for high returns, making it a key component of many portfolios.
Market Conditions
Preferred Stock: In a bear market where prices are falling, preferred stock with fixed dividends might offer a safer investment.
Common Stock: In a bull market where prices are rising, common stock with its potential for high capital gains might be more appealing.
Conclusion
Remember, the choice between preferred stock and common stock depends on your circumstances and financial goals. It is always a good idea to consult with financial experts before you choose between preferred and common stock, as this decision can significantly impact your financial outcomes.
At Qapita, we offer a range of solutions that can help startup founders like you navigate these complexities. Our platform is trusted by over 2,400+ companies and 300,000 employee-owners. With in-house equity management experts, we provide a one-stop solution to effectively handle all your equity matters from inception to IPO.
Rated as the #1 Equity Management Software by G2, our platform is designed to simplify the recording, trading, and tracking process for all stakeholders. It is a comprehensive solution for managing ownership, an effective system for equity workflow management, and a well-organized marketplace to facilitate liquidity for stakeholders.
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