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13. Common and Preferred Stock

Companies may issue different types of stock; notably common stock and preferred stock. Being familiar with the word preferred may lead you to conclude it is the better choice, but such is not necessarily the case. The customary features of common and preferred differ, providing some advantages and disadvantages for each. As you shall soon see, preferred stock is ordinarily in a better position for dividends and any liquidation proceeds, but it can be left out of significant opportunities for share value appreciation. Before digging into the specifics, be advised that the following discussion relates to general features, and the applicability of these general features can be modified on a company by company basis. Before investing in any company's common or preferred stock, you should carefully examine the specific provisions that might be unique to that company.

13.1. Typical Common Stock Features

• The right to share in a portion of dividends that are declared and issued by the company to its common shareholders.

• An option to buy a proportional part of any additional shares that may be issued by the company. This "preemptive right" is intended to allow a shareholder to avoid dilution by being assured a place in line to acquire a fair part of any corporate stock expansion. (Numerous companies have done away with this provision.)

• The right to vote on certain general governance matters like election of the Board of Directors, employee stock award plans, mergers, and similar major items.

• The right to share in proceeds of liquidation after all creditors and other priority claims are settled.

• The right to periodic financial reports about corporate performance.

Some companies go to the added trouble of having multiple classes of common stock - Class A, Class B, etc. A good example is a "family business" that has grown very large and become a public company. Such situations may be accompanied by the creation of Class A stock (held by the family members) and Class B stock (held by the public), where only the Class A stock can vote. Thus, the family has raised needed capital but preserved the ability to control and direct the company. You might also find it interesting that one can be forced out (in exchange for a fair price) of a stock ownership interest; this can occur when a company is bought out by another, and most of the other shareholders (oftentimes as high as 80 to 90%) have consented to the transaction. Non controlling shareholders (those who hold stock in a company where another party owns more than half of the corporation) are sometimes called the "minority interest." Minority shareholders are in a treacherous position, and governing laws vary considerably in how much protection is afforded to prevent the majority from engaging in transactions and activities that disadvantage the minority.

13.2. Possible Preferred Stock Features

• A preferred position for dividends. Preferred stock is paid a dividend prior to any distribution to common stockholders, and the dividend is more or less expected each period. The amount of the dividend is usually stated as a percentage of the preferred stock's "par value." Furthermore, preferred stock is frequently cumulative; if the annual dividend requirement cannot be satisfied, it will become a dividend in arrears, and all dividends in arrears must be paid before any dividends can be paid to common shareholders (in contrast to "noncumulative" where a missed dividend is not required to be made up in the future).

• The absence of voting rights.

• A preferred position in liquidation. In the event of a corporate liquidation, preferred stock is understood to be "paid-off" before common shareholders. Of course, creditors must first be satisfied before any funds will flow to either the preferred or common stockholders.

• A call feature, which means that the company can force the preferred shareholders to cash out of their position in exchange for a pre agreed "call price" that is oftentimes set at a certain percentage of "par value" (e.g., callable at 105, would mean the company can buy back the preferred stock at 105% of its par value). You don't have to think too long to see that this call provision can effectively limit the upside value of an investment in preferred stock, no matter how attractive its dividend might appear.

• A convertible feature, which means that the preferred shares may be exchanged for common stock at a preagreed ratio (e.g., 3 shares of common for one share of preferred). This conversion provision can effectively provide significant upside value for an investment in preferred stock, no matter how bad its dividend might appear.

• A maturity date, at which time the preferred will be bought back by the company ("mandatory redeemable").

Even a casual review of the above features will quickly lead you to conclude that preferred has its merits and its detractions depending on how the individual features are implemented for a particular company. Obviously, every company has different financing (and tax!) considerations and will tailor its package of features to match those issues. For instance, a company can issue preferred that is much like debt (cumulative, mandatory redeemable), because a fixed periodic payment must occur each period with a fixed amount due at maturity. On the other hand, some preferred will behave more like common stock (noncallable, noncumulative, convertible).

 
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