What Is the Difference Between Common Stock and Preferred Stock?

By | Small Business

If you've structured your business as a C corporation, you can offer two classes of stock: common and preferred. (If your business is an S corporation, then you can only offer one class.) Each class has its own set of financial terms and shareholder rights. What kind of stock you issue depends on how you want to handle dividends, and whether or not you want shareholders to have a say in your business. Here are some key differences between the two types of stock.

Common Stock

The holders of common stock can reap two main benefits: capital appreciation and dividends. Capital appreciation occurs when a stock's value increases over the amount initially paid for it. The stockholder makes a profit by selling the stock at its current market value after capital appreciation.

Dividends, which are taxable payments, are paid to a company's shareholders from retained or current earnings. Typically, dividends are paid to stockholders on a quarterly basis. Payments are usually made in the form of cash, but other property or stock can also be used. Payment of dividends, however, hinges on a company's capacity to grow -- or maintain -- current or retained earnings. This means ongoing payment of dividends cannot be guaranteed.

Common stock has the additional benefit of enabling its holders to vote on company issues and when choosing the company's leadership. Usually, one share of common stock equals one vote.

Preferred Stock

Preferred stock doesn't offer the same profit potential as common stock, but it’s a more stable investment vehicle because it guarantees a regular dividend that isn't directly tied to the market as with the price of common stock. Preferred stock guarantees dividends, which common stock does not. The price of preferred stock is tied to interest rate levels; it tends to decrease if interest rates go up and increase if interest rates fall.

Preferred stockholders get priority when it comes to the payment of dividends. If a company is liquidated, preferred stockholders get paid before those who own common stock. In addition, if a company goes bankrupt, preferred stockholders enjoy priority distribution of the company's assets; holders of common stock don't receive any corporate assets until preferred stockholders have been compensated.

Like common stock, preferred stock represents ownership in a company. However, owners of preferred stock do not get voting rights in the business.

Types of preferred stock include:

Participating preferred stock, which entitles holders to dividend increases if, during a given year, common stock dividends exceed those of preferred stock dividends.

Adjustable-rate preferred stock, which is tied to Treasury bill or other rates. The dividend is augmented based on the shifts in interest rates, determined by an established formula.

Convertible preferred stock, which has a conversion price named at its issuance so it can be converted to a company's common stock at the set rate.

Straight or fixed-rate perpetual stock, which has no maturity date because the dividend rate is set for the life of the issue.

Typically, preferred stock is favored by private companies, which often want to separate stockholders' economic interests in the company from the governance of the business. Companies that undergo multiple rounds of financing may issue multiple classes of preferred stock. Each class is granted its own set of rights (for example, "Group I Preferred," "Group II Preferred," and so on).

Issuing stock is complex. Consult this checklist so you don't miss any steps.

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