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Common Vs. Preferred Stock for Financing a Private Company Disadvantages of a Company Financing in Preferred Stock

by Tiffany C. Wright 
Some small-business owners form corporations as a vehicle for raising money for their respective businesses. Corporations can issue multiple classes of stock, but they typically issue common stock and preferred stock. Preferred stock has its name because it receives preferential treatment over common stock. Preferred stock issuance can be quicker to issue and less complex than common stock, but it also has disadvantages.

Preferred Stock

Preferred stock is treated as equity and is listed under stockholder's equity. However, it acts as a hybrid between common stock and loans. Like common stock, preferred stock gets a claim on assets in liquidation only after the company pays all creditors. Unlike common stock, preferred shares' claims on assets are senior to common shares' claims. Like debt, preferred stock pays a particular interest rate or dividend to its holder. Unlike most debt, companies make these payments on a quarterly or yearly basis instead of monthly.

Dividend Payments

Companies must pay dividends or interest payments to preferred stockholders before common stockholders. Typically, these dividends are cumulative. If companies have not paid the full amount of dividends owed to preferred shareholders, then common shareholders must forgo any dividends. For example, if a company has $10,000 available to pay dividends and it owes $12,000 to preferred shareholders, the full amount goes to pay preferred dividends. The company must pay the remaining $2,000 to preferred shareholders before any later funds go to common shareholders. Since preferred shareholders are often investors, owners and founders may not be able to receive any cash distributions until the company grows or builds up enough cash to make larger payments.

Voting and Call Feature

Preferred shares typically carry no voting rights. Companies may issue preferred shares with rights of conversion to common shares to circumvent this, but, until those shares convert, the preferred shareholder cannot vote. Some preferred shares may also be callable. This means that a company can force preferred shareholders to submit their shares in exchange for a predetermined purchase price. This limits the upside for a preferred shareholder.

Higher Asset Claims

Because preferred shareholders have a higher claim to a corporation's assets, in liquidation they receive payment after secured and unsecured creditors but before common shareholders. Unless a company has chosen to exit the business for non-financial reasons, typically few, if any, assets will remain to pay common shareholders. Therefore, owners as common shareholders may receive minimal value for their efforts in the event of business failure.




