Preferred Stock

1-sentence takeaway: Preferred stock gives investors a higher claim on a company’s assets and earnings than common stock, often with added perks, but usually without voting rights.

Think of a company’s capital structure like a layered cake. Common stockholders are at the bottom, preferred stockholders are in the middle, and debt holders are at the top. In a liquidation event (like a sale or bankruptcy), each layer gets its slice in that order—top down.

What makes Preferred Stock preferred?

• Liquidation Preference: Preferred stockholders get paid before common stockholders if the company is sold or liquidates. This preference is often expressed as a multiple of the original investment (e.g., 1x, meaning they get their initial investment back first). For example, if an investor holds Series A preferred stock with a 1x liquidation preference and invested $1 million, they’d receive $1 million before common stockholders see a dime. Learn More: [Liquidation Preference What Investors Get First]
• Dividends: Preferred stock may pay dividends, often at a fixed rate. These dividends are paid out before any dividends are paid to common stockholders. However, dividends aren’t guaranteed and are less common in early-stage companies.
• Seniority: Preferred stock sits higher in the capital structure than common stock. This seniority matters in a downside scenario—it dictates who gets paid back first.
• Anti-Dilution Protection: Preferred stock often includes provisions to protect investors from dilution in future funding rounds. A common mechanism is a “ratchet,” which adjusts the investor’s share price downward if later rounds are priced lower. Learn More: [Dilution Protecting Your Share of the Pie]

What are the trade-offs?

• Limited Voting Rights: Preferred stockholders typically have limited or no voting rights, meaning less say in company decisions.
• No Upside Participation Beyond Preference: After the preferred stockholders receive their liquidation preference (and any accrued dividends), they typically do not share in further upside gains. For example, if the company sells for a much higher price than anticipated, common stockholders benefit disproportionately.

Why do companies issue Preferred Stock?

Companies issue preferred stock to attract investors, especially in early stages where the company is considered higher risk. The preferential terms offer investors some downside protection, making them more willing to invest.

Why is this relevant to the secondary market?

Understanding the rights and limitations associated with preferred stock is crucial for both buyers and sellers on the secondary market. The type of preferred stock (Series A, Series B, etc.), its liquidation preference, and other provisions can significantly impact its value. Learn More: [Understanding Private Market Valuations]

So here’s what we covered:

• Definition of Preferred Stock
• Advantages of holding Preferred Stock (Liquidation Preference, Dividends, Seniority, Anti-Dilution Protection)
• Disadvantages of holding Preferred Stock (Limited Voting Rights, Capped Upside)
• Why companies issue Preferred Stock
• Relevance of Preferred Stock to the secondary market