In our last blog we detailed what preferred stock is as well as some important components and variations of it, including liquidation preference, antidilution rights, and voting rights. There are numerous variations of preferred stock, which can be tailored to the specific needs of each company and its preferred stockholders. In Part II of this blog, we’ve provided explanations for more of the various aspects and components that preferred stock can entail.
A company may have more than one outstanding series of preferred stock at a time, and it will designate which “series” of preferred stock has priority over another. Shareholders with senior preferred stock will take priority over other more junior series of preferred stock. The senior preferred stock will be the first to receive liquidation preferences if a company only has enough money to pay some of the obligations to its senior preferred stockholders. Sometimes different series of stock will be equal in priority to others series of preferred stock (i.e., parri-passu).
Cumulative & Non-Cumulative Dividends
The special characteristic of cumulative preferred stock is that, if the dividend is not paid for any reason, then the stock will accumulate the unpaid dividend to be paid at a later date. Any of the accumulated unpaid dividends must be paid to the cumulative preferred stockholders before any dividends can be paid to common stockholders (or other junior securities). Conversely, for non-cumulative preferred stock, if the company cannot pay the dividends for any reason, then they will be lost and will not accumulate.
Participating & Non-Participating
Upon a liquidation event (e.g., sale of the company), Stockholders holding “non-participating” preferred must typically make a choice: they can choose to take their liquidation preference (see Part I of this blog post) or they can choose to convert their preferred stock into common stock and reap more than just their liquidation preference (see “convertible” below). Of course, the stockholders will choose whichever outcome that yields them the greatest economic value.
If the preferred stock is “participating preferred,” however, then the stockholder doesn’t need to make the choice. Instead they will first be entitled to their liquidation preference and then, once the liquidation preference has been satisfied, their preferred stock will be automatically converted into common stock so that they can “participate” in additional distributions after that. All things held equal (e.g., liquidation preferences), “participating preferred” stock will always yield a better outcome for the preferred stockholders.
Preferred stock liquidation preferences are fixed, so if the company does extremely well then the value of common stock may outpace the preferred stock. In this case (and when the preferred stock is not “participating preferred”), convertible preferred stock comes in handy. Convertible preferred stock allows the holder to convert his or her preferred stock to common stock at any time they wish. No matter the value of the common stock, the preferred stock can be exchanged for a predetermined number of shares of common stock. However, they cannot be converted back into preferred stock later.
The rights, superlatives, and other components of preferred stock can vary drastically from company to company; so, whether you are investing in preferred stock or issuing it, it is important you understand exactly what your company’s preferred stock will entail. The Doida Law Group can help! If you have questions about issuing preferred stock or investing in a company with preferred stock, please contact us to learn more.