Let us start with common or ordinary shares. In the broadest definition these are usually voting shares representing proportional ownership of the firm and they sometimes pay dividends.
Because they represent the ultimate ownership of the company, they are usually last in line if the company goes into liquidation. Employees, creditors and bondholders have priority. Common shares are usually the top choice for investors looking to participate in the growth of the business.
Preferred, or preference, shares bear the name because of the advantages they offer the holder:
• Seniority to common (or ordinary) shares
An advantage in the event of liquidation, although the shares are subordinate to bonds in this event.
• Pay-established dividends.
Attractive to investors seeking an income vehicle.
Preferred dividends must be paid before common stock dividends.
Should the firm cease paying dividends, it cannot resume paying dividends on common shares until the preferred shareholders have all been paid their total dividends in arrears.
Unlike bonds, many preferred shares are listed securities. This benefits retail investors seeking to sell small positions. If the shares are thinly traded, spreads could be an issue.
• Tax Treatment
In the US, preferred dividends are taxed at 15 per cent for most investors and 20 per cent for those in the top marginal bracket. Income from bonds is considered interest and is taxed at the holder’s tax rate, which can be as high as 39.6 per cent. UK taxation varies between 10 per cent to 42.5 per cent although the UK taxpayer receives a tax credit representing 10 per cent of the dividend amount.
• Callable (or redeemable)
Like bonds, preferred shares often allow the issuer to redeem the shares after several years. This is a major disadvantage for investors seeking to lock in income in a declining rate environment.
Preferred shareholders usually do not share in the capital appreciation potential of common shares. The higher level of income they are collecting is considered compensation.
Common shareholders vote on directors and major shareholder issues. Preferred shareholders do not, except in extraordinary events.
Some preferred shares include an option to exchange the shares for a specified amount of common shares. This allows the holder to participate in the value appreciation if a firm is doing well. Typically, once shareholders have exercised this right they cannot convert back into preferred shares. Convertible bonds offer similar benefits.
Some preferred shares allow the holder to sell the shares back to the issuer at a set price within a specified time period.
• Poison pill protection
In the heyday of hostile takeovers, companies allowed classes of preferred shares to exercise voting rights as a form of ‘shark repellent’. Other features were sometimes built in as potential defences, yet in the UK its use is more restrictive.
Railroads issued the first preferred shares in the US during the 1830s. Today, banks and other financial institutions issue most preferred shares.