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Preferred shares are shares in a company which pay out a fixed dividend. A number of things about these shares are unique, but one of their most critical feature is that dividends must be paid out to holders of these shares before they can be paid out to holders of common shares. This explains the use of the term “preferred,” as these shares are ranked above common shares when it comes to making payouts.
These shares rank between bonds and common shares. Bonds pay out a fixed dividend, no matter what. Preferred shares get a fixed dividend, but that dividend is not a legal obligation, which means that when the company experiences financial trouble, preferred shareholders may not receive dividends. Common shares pay out a fluctuating dividend, depending on the health of the company.
Holders of preferred shares do not have voting rights. They also do not have access to the potential profits that common shareholders do, because the dividend is fixed. Conversely, this means that they are insulated if the company declines in value or experience a downturn in its fortunes. Preferred shares are often issued when a company is first starting, to raise capital and allow people to get in on the start of the business.
There are a number of different types of preferred shares. Convertible shares allow people to convert their shares to common stock, often at a fixed rate. This can be handy when common stock soars in value, as the shareholder can trade in and make a profit. Cumulative preferred shares allow companies to miss a dividend, but require that the dividend be repaid in the future, while non-cumulative shares allow companies to skip dividends without such penalties. Participating preferred shares allow the option of an extra dividend in the event that the company is performing well.
Some preferred shares have a maturity date, at which point the share must be redeemed for cash or converted into common shares. Others are perpetual, with no maturity date, and some allow for flexibility, with shareholders opting to cash out, convert, or hold onto the shares when they mature.
There are advantages and disadvantages to this type of share which should be weighed carefully before purchasing such shares. Financial advisors can often provide input on the best investment option, on the basis of the investor's needs and the history of the company which the investor is considering buying shares in.
Holders of preferred shares also tend to recover more when a company files for bankruptcy, another reason why they can be a good investment.
Common shareholders rarely get anything under a bankruptcy plan. However, holders of preferred shares will often get something in return for their investment.
Most commonly, preferred shareholders will either be paid in kind in a bankruptcy, meaning they will receive new preferred shares in exchange for their existing ones, or they will agree to convert their shares into common shares in the reorganized company.
Despite the better odds of recovery for preferred shareholders over common shareholders, preferred shareholders still must wait for all senior claims to be paid in full before they receive any sort of distribution.
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