Preferred Stock vs Common Stock: Key Differences

Preferred stock and common stock represent different classes of equity ownership with distinct rights and characteristics. Preferred shares typically offer fixed dividend payments and liquidation preference, while common shares provide voting rights and unlimited upside potential in company growth.

Definition and Basic Characteristics

Preferred stock and common stock are two fundamental types of equity securities that companies issue to raise capital. Each class carries unique features that appeal to different types of investors and serve distinct purposes in corporate finance structures.

Common stock represents the most basic form of ownership in a corporation. When investors purchase common shares, they become partial owners with claims to the company's assets and earnings proportional to their shareholdings.

Key Features of Common Stock

Common stockholders enjoy several fundamental rights:

• Voting rights on major corporate decisions • Residual claim on company assets and earnings • Potential for capital appreciation without limits • Variable dividend payments when declared by the board • Transferability through public or private markets

Preferred stock occupies a hybrid position between bonds and common equity. These shares combine features of both debt and equity instruments, offering more predictable returns than common stock but less upside potential.

Distinguishing Characteristics of Preferred Shares

Dividend Rights and Payments

The most significant operational difference between preferred and common stock lies in their dividend structures. Understanding these distinctions helps investors choose the appropriate security for their income needs and risk tolerance.

Preferred Stock Dividend Features

Preferred stockholders receive fixed dividend payments that must be satisfied before any distributions to common shareholders. This priority creates a more stable income stream similar to bond interest payments.

Types of Preferred Dividend Structures

1. Cumulative Preferred Stock • Unpaid dividends accumulate as "dividends in arrears" • All accumulated dividends must be paid before common distributions • Provides strongest protection for income investors

2. Non-Cumulative Preferred Stock • Missed dividends are permanently forfeited • Lower protection but typically higher yield • More common in financially stable companies

3. Participating Preferred Stock • Receives stated dividend plus additional participation • Shares in excess profits with common stockholders • Rare but valuable in high-growth scenarios

Dividend Payment Calculations

Consider a company with the following capital structure: • 1,000 shares of 6% cumulative preferred stock ($100 par value) • 10,000 shares of common stock

Annual preferred dividend requirement: 1,000 × $100 × 6% = $6,000

The company must pay this $6,000 to preferred shareholders before any common dividends. If the company skips a year, the $6,000 becomes dividends in arrears that accumulate.

Common Stock Dividend Variability

Common stock dividends fluctuate based on company performance and board decisions. Unlike preferred dividends, these payments are entirely discretionary and can be increased, decreased, or eliminated without legal consequences.

Factors Affecting Common Dividends

Financial Performance Metrics:

1. Earnings per share (EPS) growth
2. Free cash flow generation
3. Debt service requirements
4. Capital expenditure needs
5. Economic conditions and industry trends

Dividend Policy Types

Voting Rights and Corporate Control

The allocation of voting rights represents a critical distinction that affects corporate governance and investor influence. This difference fundamentally shapes how different shareholders participate in company decisions.

Common Stock Voting Power

Common stockholders typically receive one vote per share on major corporate matters:

• Board of directors elections • Mergers and acquisitions • Corporate charter amendments • Stock splits and dividends • Executive compensation plans

Preferred Stock Voting Limitations

Most preferred stock carries no voting rights under normal circumstances. However, voting rights may activate under specific conditions:

Contingent Voting Rights Triggers: • Dividend payments missed for specified periods (typically 6-8 quarters) • Company attempts to issue senior securities • Proposed changes adversely affecting preferred rights • Bankruptcy or reorganization proceedings

Control Implications for Startups

In startup environments, the voting rights distinction becomes particularly important:

Founder Considerations:

1. Maintain control by issuing non-voting preferred to investors
2. Protect decision-making authority during growth phases
3. Prevent hostile takeovers through voting share concentration

Investor Perspectives:

1. Venture capitalists often negotiate for board seats despite holding preferred
2. Protective provisions substitute for direct voting rights
3. Conversion rights to common stock preserve upside participation

Liquidation Priority and Asset Claims

During company liquidation or bankruptcy, the order of payment becomes crucial. The seniority structure determines who gets paid and how much they receive from remaining assets.

Liquidation Preference Hierarchy

The typical payment waterfall follows this priority:

1. Secured Creditors • Banks with collateral claims • Asset-backed lenders

2. Unsecured Creditors • Bondholders • Trade creditors • Employees (wages)

3. Preferred Stockholders • Receive par value plus accumulated dividends • Multiple series paid by seniority

4. Common Stockholders • Receive remaining assets (if any) • Often receive nothing in bankruptcy

Liquidation Preference Example

Consider a company liquidating with $10 million in assets:

Per-share recovery: • Preferred: $1,000 per share (100% of par value) • Common: $100 per share (10% of typical value)

Startup Liquidation Preferences

Venture capital preferred stock often includes participation rights that enhance returns:

Non-Participating Preferred: • Choose between liquidation preference OR conversion to common • Cannot double-dip on proceeds

Participating Preferred: • Receive liquidation preference PLUS share in remaining proceeds • Effectively get paid twice

Capped Participation: • Participation limited to specific multiple (e.g., 2x or 3x) • Balances investor protection with founder interests

Investment Risk and Return Profiles

Understanding the risk-return characteristics helps investors align security selection with their financial objectives. Preferred and common stocks occupy different positions on the risk spectrum.

Risk Analysis Comparison

Return Potential Assessment

Preferred Stock Returns:

Preferred stockholders generate returns through:

1. Fixed dividend income (primary source)
2. Modest capital appreciation (limited)
3. Call premium (if redeemed above par)

Typical Annual Returns: 4-8% in stable markets

Common Stock Returns:

Common stockholders benefit from:

1. Dividend income (if paid)
2. Capital appreciation (unlimited upside)
3. Stock splits and spin-offs
4. Rights offerings participation

Historical Annual Returns: 8-12% long-term average for S&P 500

Portfolio Allocation Strategies

Conservative Portfolio (Income Focus): • 40% Bonds • 30% Preferred stocks • 20% Dividend-paying common stocks • 10% Cash

Balanced Portfolio: • 30% Bonds • 15% Preferred stocks • 45% Common stocks • 10% Alternatives

Aggressive Portfolio (Growth Focus): • 10% Bonds • 5% Preferred stocks • 75% Common stocks • 10% Alternatives

Market Performance and Valuation

Valuation methodologies differ significantly between preferred and common stocks due to their distinct cash flow characteristics. Understanding these differences helps investors make informed pricing decisions.

Preferred Stock Valuation Methods

Perpetuity Model: The most common approach treats preferred stock as a perpetual annuity:

Value = Annual Dividend ÷ Required Rate of Return

Example: A $100 par preferred paying 6% annually with 7% required return: Value = $6 ÷ 0.07 = $85.71

Common Stock Valuation Approaches

Fundamental Valuation Methods:

Market Behavior Patterns

Interest Rate Sensitivity:

Preferred stocks behave like bonds when rates change: • Rising rates → Preferred prices decline • Falling rates → Preferred prices increase • Common stocks show less direct correlation

Economic Cycle Performance:

Expansion Phase: • Common stocks outperform (growth opportunity) • Preferred stocks provide steady returns

Recession Phase: • Preferred stocks outperform (stability) • Common stocks experience significant declines

Recovery Phase: • Common stocks lead recovery (highest upside) • Preferred stocks lag but remain stable

Conversion Features and Hybrid Valuations

Convertible Preferred Stock adds complexity by combining features:

Conversion Ratio Calculation: • Par Value ÷ Conversion Price = Number of common shares

Conversion Value: • Conversion Ratio × Current Common Price

Investment Value: • Straight preferred value without conversion

The convertible trades at the higher of conversion or investment value, creating a floor price with upside participation.

Frequently Asked Questions

What is the main difference between preferred and common stock?

The primary difference is that preferred stock offers fixed dividend payments and liquidation priority but typically lacks voting rights, while common stock provides voting rights and unlimited growth potential but carries higher risk and no guaranteed dividends. Preferred shareholders are essentially creditors with equity features, whereas common shareholders are true owners.

Can preferred stock be converted to common stock?

Some preferred stocks include conversion features allowing holders to exchange their shares for a predetermined number of common shares. Convertible preferred stock is particularly common in venture capital investments, where investors want downside protection initially but the ability to participate in upside if the company succeeds. The conversion ratio is typically set at issuance.

Which type of stock is better for retirement income?

Preferred stock generally provides more reliable retirement income due to its fixed dividend payments and payment priority over common dividends. However, preferred stock lacks inflation protection since dividends don't typically increase. A balanced approach might include both preferred stocks for stability and dividend-growing common stocks for inflation protection.

Do preferred stockholders have any voting rights?

While preferred stockholders typically don't have voting rights under normal circumstances, they may gain voting rights if the company misses dividend payments for a specified period (usually 6-8 quarters) or attempts to make changes that adversely affect their rights. These contingent voting rights protect preferred shareholders' interests during distress.

How are preferred and common stocks taxed?

Both preferred and common stock dividends are generally taxed at the qualified dividend rate (0%, 15%, or 20% depending on income level) if holding period requirements are met. Capital gains from selling either type of stock receive capital gains treatment. The key difference is that preferred dividends are more predictable for tax planning purposes.

What happens to preferred stock in a merger or acquisition?

During mergers or acquisitions, preferred stockholders typically receive their liquidation preference value, which includes par value plus any accumulated dividends. Some preferred stocks include change-of-control provisions that trigger conversion to common stock or redemption at a premium. The specific treatment depends on the preferred stock's terms and the deal structure.

Why do startups issue preferred stock to investors?

Startups issue preferred stock to investors to provide downside protection through liquidation preferences while allowing founders to retain voting control through common stock. This structure aligns interests by giving investors financial preferences without diluting founder control. The preferred stock often includes anti-dilution provisions and board representation rights that protect investor interests without requiring voting control.

Can individual investors buy preferred stock?

Yes, individual investors can purchase preferred stocks through brokerage accounts, particularly those issued by large corporations and traded on major exchanges. Many preferred stocks trade under separate ticker symbols (often with a "PR" suffix). However, startup preferred stock is typically restricted to accredited investors and isn't publicly traded.

Conclusion

Understanding the distinctions between preferred and common stock enables investors to construct portfolios aligned with their risk tolerance and financial objectives. Preferred stock offers stability and income priority suitable for conservative investors, while common stock provides growth potential and ownership rights appealing to those seeking long-term wealth creation.

The choice between preferred and common stock isn't mutually exclusive—many successful portfolios incorporate both to balance income generation with growth potential. For startup founders and employees, understanding these differences is crucial when evaluating equity compensation and investment opportunities.