Common Stock vs Preferred Stock

This reading defines an equity instrument, compares common shares with preference shares and their features, and contrasts public equity with private equity and its four main types.

LOS 39.a — What an equity instrument is, and the main types

An equity instrument is a security that gives its holder ownership of part of a corporation. The owners (shareholders) share in whatever is left of the company's assets after higher-ranking claims (debts, taxes) are met, and they may be able to vote on company policies and decisions. Their liability is limited. If the company goes bankrupt they can lose what they invested, but they are not otherwise liable for the company's obligations.

Equity versus debt

Dividends and the company life cycle

A company's willingness to pay dividends usually changes as it moves through four phases:

• Start-up phase: little or no revenue, negative cash flow as invested capital is spent building the business; nothing to distribute.
• Growth phase: revenue rising and cash flow may turn from negative to positive, but earnings are mostly reinvested to grow the business.
• Mature phase: stable cash flows and fewer growth opportunities, so shareholders prefer that earnings be distributed regularly as dividends. This is the phase most associated with dividend payments.
• Decline phase: falling revenue and cash flow; future dividends become doubtful.

Rights disclosed in an equity prospectus

When equity is issued, the equity prospectus describes the security's features and how the money raised will be used. It states whether the security carries:

• voting rights on company matters;
• dividend rights (regular or special dividends);
• conversion rights: to change the security into another type, such as preferred into common shares;
• liquidation rights: what the holder receives if the company is dissolved;
• split, subdivision, or combination rights: how the holder's position is treated if shares are split, divided or combined;
• preemptive rights: a first opportunity to buy any new shares the company issues in the future (protecting the holder's proportional stake).

Common shares

Common shares are the most widely issued form of equity. Common shareholders:

• have a residual claim on the firm's assets in liquidation: they are paid only after debtholders, other creditors and preferred shareholders;
• govern the company through voting rights: electing the board of directors, approving mergers, selecting auditors. A shareholder who cannot attend the annual meeting can vote by proxy (someone else casts the vote as instructed);
• receive variable dividends that the company has no legal obligation to pay.

The company benefits because it raises capital while retaining control of its operations; investors benefit because they can own a fraction of a large company with a small outlay.

Preference shares (preferred stock)

Preference shares (preferred stock) are a hybrid of common stock and debt:

Preferred shares have a stated par value and pay a dividend equal to a fixed percentage of par. If the firm is liquidated, preferred holders may receive a set liquidation preference payout before common shareholders receive anything.

Types of preference shares:

For the embedded options in the table, whose right it is tells which way the option moves value and risk. A holder's put or conversion right makes the shares more valuable than otherwise identical shares without it, while an issuer's call right makes them less valuable. Preferred shares are less risky than the same company's common shares because preferred distributions, when declared, and preferred liquidation claims rank ahead of common claims. Cumulative shares are less risky than noncumulative shares because a skipped cumulative dividend must be made up before any common dividend can be paid. Reading 44 applies the option-value relationship when valuing preferred stock.

Participating preferred stock is often issued by smaller, riskier firms, whose investors want a share of the upside. Convertible preferred shares are common in financing risky early-stage firms: the conversion option compensates investors for risk and lets the firm raise capital more cheaply than by issuing common shares.

LOS 39.b — Public versus private equity

Private equity is usually issued to institutional investors through private placements, and there is no public market for it. Both private firms and publicly listed firms can issue private equity (a listed company selling shares privately is an example).

How private equity differs from public equity

Public equity, by contrast, tends to feature larger, mature-stage companies with dispersed ownership, liquid secondary markets and public reporting requirements.

The four main types of private equity investment

1. Venture capital: capital for firms early in their life cycle (start-up, development, early growth). Providers include family, friends, wealthy individuals and private equity funds. Investments are illiquid; investors' money is usually tied up for several years before an exit is possible.
2. Growth equity: capital a firm raises during its growth stage (e.g., to expand). Bringing in growth equity investors can dilute the concentrated ownership typical of the venture capital stage.
3. Buyout equity: focuses on mature-stage companies that investors believe are underperforming and could be improved by restructuring operations or capital.
   • Take-private transaction: a buyout of a publicly traded company in which the investing group assumes full control (the shares are delisted).
   • Leveraged buyout (LBO): buying all of a firm's equity using debt financing (leverage); targets usually have enough cash flow to service the debt, or undervalued assets whose sale can pay it down over time.
   • Management buyout (MBO): an LBO in which the buyers are the firm's current managers.
4. Special situations: investments in distressed firms (e.g., decline stage) or firms that are restructuring or reorganizing. One form is a private investment in public equity (PIPE): a listed firm that needs capital quickly sells equity privately to a select group of investors.