Preferred stock has benefits
By Hal Heaton
Brigham Young University
One of the most common forms of investment for private equity — especially venture capital — in new business ventures is convertible preferred stock. Convertible preferred stock makes sense for high-risk investments for a number of reasons.
Convertible preferred is a hybrid of debt and equity. It is senior to equity, which means that in the event of business failure, preferred shareholders receive all their
investment back from liquidation proceeds before common shareholders receive payment. It is junior to debt, which means that in the event of business failure,
debt holders must be paid off before preferred shareholders receive any payment. Like debt, preferred stock pays a fixed cash flow, called dividends, usually on a
quarterly or annual basis.
The problem with straight common stock is that most of
the time the entrepreneur retains controlling interest and
the investor has only limited control of the investment.
Preferred stock allows the investor to impose specific
restrictions and covenants over entrepreneurial behavior.
This is critical since many new ventures fail, and in the
process of failing the entrepreneur may take desperate
measures to try to preserve the enterprise. In the event of
bankruptcy, the seniority of preferred over common
allows investors to step in and protect the remaining
assets.
The convertibility clause provides upside potential. It
allows the investor to convert, or send in their preferred
shares and receive common shares.
Investors typically will not convert without a reason.
Preferred shareholders have all the upside potential of the
common. Since they can convert at will, the preferred
shares must sell for at least the value of the common
shares that the preferred can convert into. Usually, the
preferred shares sell for more than the value of the
underlying shares.
There are two reasons why the convertible preferred is
worth more than the underlying shares into which they
can be converted. »»» Click Here For More
