Preferred Stock – Definition, Types, and How It Works
How Preferred Stock Works
When a company issues preferred stock, it promises shareholders a stated dividend — usually expressed as a percentage of par value or as a fixed dollar amount per share. This dividend must be paid before any dividend reaches common stockholders.
If the company is liquidated, preferred shareholders get paid after bondholders but before common shareholders. That seniority is the core trade-off: you get more income certainty and downside protection, but you give up the unlimited upside that common stockholders enjoy.
Most preferred shares trade on the same exchanges as common stock, but they behave more like bonds. Their prices are heavily influenced by interest rate movements — when rates rise, preferred stock prices tend to fall, and vice versa.
Types of Preferred Stock
| Type | Key Feature | Investor Benefit |
|---|---|---|
| Cumulative | Unpaid dividends accumulate and must be paid before common dividends resume | Strongest dividend protection — missed payments don’t disappear |
| Non-Cumulative | Missed dividends are gone for good | Often carries a higher stated yield to compensate for the risk |
| Convertible | Can be converted into a set number of common shares | Upside participation if the common stock rallies |
| Callable | Issuer can redeem shares at a set price after a specific date | Usually issued at a higher yield to offset the call risk |
| Participating | Receives extra dividends on top of the stated rate when the company exceeds certain profit thresholds | Combines downside protection with upside sharing |
| Adjustable-Rate | Dividend rate resets periodically based on a benchmark (e.g., Treasury yield) | Lower interest rate risk compared to fixed-rate preferreds |
Preferred Stock vs. Common Stock
| Feature | Preferred Stock | Common Stock |
|---|---|---|
| Dividends | Fixed, paid first | Variable, paid after preferred |
| Voting Rights | Usually none | Yes — one vote per share |
| Price Appreciation | Limited (behaves more like a bond) | Unlimited upside potential |
| Liquidation Priority | Higher — paid before common | Last in line after all creditors and preferred holders |
| Interest Rate Sensitivity | High | Lower |
| Best For | Income-focused investors | Growth-focused investors |
Preferred Stock Dividend Example
Say a company issues preferred stock with a $100 par value and a 6% annual dividend rate. Each share pays $6.00 per year (usually $1.50 per quarter). If the company also pays common dividends, those $6.00 per preferred share must be distributed first.
$6.00 = $100 × 6%
If the preferred shares are cumulative and the company skips two years of payments, it owes $12.00 in back dividends per share (called “dividends in arrears”) before a single cent goes to common shareholders.
Why Companies Issue Preferred Stock
Companies issue preferred stock for several strategic reasons. Unlike bond interest, preferred dividends are not tax-deductible — so the motivation isn’t usually a tax play. Instead, preferred stock lets companies raise capital without diluting voting control (since preferreds typically carry no votes) and without adding fixed obligations that show up as debt on the balance sheet.
Banks and financial institutions are particularly heavy issuers because regulators count certain preferred stock toward Tier 1 capital requirements, strengthening the bank’s capital ratios without issuing more common equity.
Who Buys Preferred Stock?
Preferred stock appeals to two main groups. Income investors buy it for the higher yield — preferred dividends are typically larger than common stock dividends and often qualify for the favorable qualified dividend tax rate. Institutional investors, especially corporate buyers, are attracted by the dividends-received deduction (DRD), which allows corporations to exclude a large portion of preferred dividends from taxable income.
Risks of Preferred Stock
Preferred stock carries a specific set of risks investors need to understand. Interest rate risk is the biggest factor: when rates climb, preferred prices drop — sometimes sharply — because investors can get comparable yields elsewhere. There’s also credit risk: if the issuing company deteriorates financially, dividends can be suspended (and with non-cumulative preferreds, those payments are lost permanently). Finally, the limited price appreciation means you won’t capture the kind of capital gains that common stockholders enjoy during strong bull markets.
Preferred Stock in Venture Capital and Startups
In venture capital and private equity, preferred stock takes on a different character. VC-issued preferred shares typically include liquidation preferences (e.g., 1x or 2x the invested amount), anti-dilution provisions, and conversion rights. These protections ensure that investors get their money back before founders and employees holding common stock see any returns in an exit event.
Key Takeaways
- Preferred stock is a hybrid security — more predictable income than common stock, more upside than bonds.
- Preferred dividends must be paid before common dividends, and preferred holders rank higher in liquidation.
- Major types include cumulative, convertible, callable, participating, and adjustable-rate preferred shares.
- Preferred stock prices are heavily sensitive to interest rate movements.
- In the VC/startup world, preferred stock includes liquidation preferences and anti-dilution protections.
Related Terms
| Term | Relevance |
|---|---|
| Common Stock | The other major class of equity — carries voting rights and unlimited upside |
| Dividend | The income payment that makes preferred stock attractive |
| Dividend Yield | How to measure the income return on a preferred share |
| Par Value | The face value used to calculate preferred dividend payments |
| Convertible Bond | Another hybrid security that can convert into common equity |
| Dilution | What convertible preferred shares can cause when converted to common |
Frequently Asked Questions
Is preferred stock safer than common stock?
In terms of income stability and liquidation priority, yes. Preferred stockholders receive dividends first and are ahead of common stockholders in a liquidation. However, preferred stock still carries meaningful interest rate risk and credit risk, and it doesn’t offer the same upside potential as common equity.
Can preferred stock go up in price?
It can, but price appreciation is usually modest. Preferred stock trades more on yield than growth. Convertible preferreds are the exception — their value can rise significantly if the underlying common stock appreciates beyond the conversion price.
Do preferred stockholders have voting rights?
Typically no. Most preferred shares do not carry voting rights. Some preferred issues grant limited voting rights under specific conditions, such as when dividends have been in arrears for a certain number of consecutive quarters.
How is preferred stock taxed?
Preferred dividends from U.S. corporations generally qualify for the lower qualified dividend tax rate (0%, 15%, or 20% depending on your income bracket), rather than being taxed as ordinary income. However, preferred dividends from REITs and certain foreign issuers may not qualify for this favorable treatment.
What happens to preferred stock if a company goes bankrupt?
Preferred stockholders are paid after all creditors (bondholders, banks, trade creditors) but before common stockholders. In practice, if a company enters bankruptcy, preferred stockholders often receive very little or nothing — most of the recovery goes to secured and senior unsecured creditors.