Common Stock vs. Preferred Stock: Know the Differences
The Differences Between Common Stock and Preferred Stock
A corporation can raise money in many ways. One of the more common ways is to sell shares of stock. There are two types of stock – common stock and preferred stock – although there can be classes within each type of stock. Depending upon their goals, investors in stocks may choose to buy one type of stock or the other if the corporation offers both. It is important for an investor to know the differences between the two types of stock.
Common stock is the most widely known type of stock and is the only type of stock that the law requires a corporation to issue. Common stockholders have equity in the corporation because common shareholders own the corporation. Common shareholders have the right to vote for corporate directors and to decide to approve or disapprove of certain, major corporate decisions, such as selling off substantial corporate assets, mergers and acquisitions, incurring large amounts of debt or dissolving the corporation.
Common stock entitles the stockholder to corporate dividends if there are any dividends. However, preferred stockholders are paid dividends before common stockholders are paid. If there is insufficient money to pay dividends to common shareholders, then they do not receive any dividends.
Preferred stock, in contrast, does not grant equity in the corporation to the stockholder. Moreover, preferred stockholders typically have no voting rights in the corporation (however, there are instances where preferred shares are entitled to vote on special matters before the corporation or if the corporation has failed to pay dividends on preferred shares for some time). For these reasons, preferred stock is more comparable to a bond than it is to common stock. However, while preferred stock is senior to common stock it is subordinate to bonds. There is a fixed dividend, much like a coupon rate for a bond, that entitles the preferred stockholder to be paid, without fail, as long as the corporation remains viable. Preferred stock is said to have a preference with respect to dividend payments by the corporation. This preference does not guarantee dividend payments on the part of a corporation, but a corporation is required pay the dividends on preferred shares before or at the same time as dividends are paid to common shareholders.
Sale of the Corporation
It is possible that any corporation will be purchased by another corporation. For this to occur, the purchasing corporation must buy the shares of the common stockholders because they are the ones who own the company. A preferred shareholder will not share in the common stock’s appreciation because preferred stock does not carry an equity interest in the corporation. However, some types of preferred shares include a provision allowing the preferred shareholders to convert their preferred shares into common shares of stock upon sale of the corporation.
Investment Differences Between Common and Preferred Stock
The more practical differences between the two types of stock lie in the preferences of the investors. With common stock, there is potential that the investment can be lost entirely. There is also the potential that the value of the that stock could soar.
With preferred stock, the stockholder receives distributions at a fixed rate which tends to be higher than that received by common stockholders. If the company fails, the preferred stockholders will be paid before the common stockholders if there is any money left after senior creditors have been paid.
Thus, an investor who seeks long-term appreciation without necessarily receiving dividends usually chooses to purchase common stock. A more conservative investor, who is interested in a fixed income rather than in appreciation over time, will likely opt to invest in preferred stock.
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