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Thursday, September 15, 2011

What are Preferred Shares?

Preferred shares are hybrid instruments with the properties of both equity and debt instruments.
When a company goes broke, proceeds generated from the liquidation are given to Preferred Share Holders before the Common Equity Holders. Preferred share holders are paid only after the settlement of the debtors and bond/debenture holders. Preferred shares holders are not entitled for the voting rights .Share holders get a guaranteed dividend at pre-determined rate ( also termed as interest by many )before any dividend payout to equity share holders.
What is Liquidity Preference?
When 1 dollar invested in a company fetches 1.5 dollars in case of the liquidation, it is called 1.5X Liquidation Preference.
Generally liquidation preferences are 1X, 1.5X and2 X.
So if a venture capitalist invests 1 million USD in a company with the liquidity preference of 2X then in case of that company’s liquidation he shall get 2 million USD.
Convertible vs. Non-Convertible Preferred Shares
Sometime it is beneficial to have common equity than having preferred shares, and to plug this loop-hole investors seek the option to convert the preferred shares into the common equity. Convertible Preferred Stocks can be converted into common equity at the pre-determined rate while Non-Convertible Preferred Stocks can’t be converted into common equity.
Participating Vs. Non Participating Preferred Shares
In case of the liquidation non-participating preferred shareholders get their invested amount as per liquidation preference of 1X, 1.5X or 2X and unpaid accrued fixed dividend.
Common equity holders get the remainder amount (amount left after the payment of fixed dividend to preferred share holders) but sometimes it is better to have common equity, which is illustrated in the following example.
Company ABC’s capital structure-
·         20,000 Non-Participating Preferred Shares constituting the investment of 10,00,000 $ with the liquidity preference of 2X
·         80,000 Common Equity Shares
If ABC gets liquidated for $ 10,00,00,000 then  Non-Participating Preferred Share Holders shall get 20,00,000 $, which is  $100 per share and remaining shall be distributed amongst the equity share holders and the same comes out to be $ 1225.
In the aforesaid case, it is better to have equity shares than Non Participating Preferred Shares.
Participating Preferred Shares give the double benefit apart from the amount receivable to Non –Participating Preferred Shares, they also share the remaining proceeds to be distributed among the Common Equity Share Holders.
In the above example, let’s calculate the amount payable to Preferred Share Holders, if all preferred shares are Participating Preferred Shares –
Participating Preferred Share holders shall share the amount (with the common equity holders) left after the payment of fixed dividend to the Preferred Share Holders.
·         20,000 Non-Participating Preferred Shares constituting the investment of 10,00,000 $ with the liquidity preference of 2X
·         80,000 Common Equity Shares
Liquidation amount: $ 10, 00, 00,000
Fixed dividend payment to Preferred Share Holders: $ 20, 00,000
Amount payable as preferred share dividend: $20, 00,000
Preferred share holders dividend per share: $100      …….. (A)
Remaining amount: $9, 80, 00,000
Now this remainder shall be divided between common equity share holders and participating preferred share holders.
Amount payable per share to common equity share holder and participating preferred share holders:  $ 980 ………….. (B)
So participating shareholders shall get $1080 (A+B) while equity share holders shall get $ 980 only.
Common stock vs. preferred stocks

Common stock
Preferred stock
Only after dividend payment to preferred shares
guaranteed dividend at a pre-determined interest rate prior to the common  stock dividend payout
Voting Rights
Common stock carries voting rights
No voting rights
Convertible stocks can be converted into common equity
Liquidation preference after debtors and preference shares
Liquidation preference only after debtors
Participating and Non-Participating Preferred Shares



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