The Lazy CEO Podcast

Preferred Stock

by May 1, 2023The Lazy CEO Podcast

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In this episode of Preferred Stock

  • What is common stock?
  • What is preferred stock?
  • Examples of cumulative, non-cumulative, and participating preferred stock.

Here is a glimpse of Preferred Stock

Today we’re going to talk about stock. As you know, there is common stock and preferred stock, but we will dig deep into preferred stock because it is a less understood instrument. It’s particularly important for entrepreneurs because this is an investment vehicle used by private equity firms. So if you are ever considering either a partial sale, maybe bring in some cash or cash for growth, or maybe even a total sale.

You need to understand the ins and outs of private equity because this is the way that private equity firms use to gain control to gain preference to get to the front of the line. Sometimes that can have tragically bad consequences for you as an entrepreneur. This is also relevant for anybody who’s sort of in an early-stage company because preferred equity is used all the time in the early stage. It can have odd and complicated outcomes if you are not careful. You may not have a choice, but at least you know what you’re signing up for.

Common Stock

If I buy common stock, I have a little piece of a company; I get a vote. We’re in a season where we’re all getting our request for voting for annual meetings – you get to vote for your board of directors who represent your interests in the company and so forth. And if there are dividends, meaning the company does well then you get a share of those dividends, right?  Provided, of course, that the company does well. Some of these companies hesitate to drop their dividend rate because it can hurt their share price. But, you are at risk on your dividend.

Preferred Stock

We don’t play any funny games with preferred stock. When you bring in your friends and family, your first round of money, your first half a million or million, and you got Uncle Bob and, your neighbor and a few other people coming in, normally you are selling them common stock when you do that. So that was common stock, and there was no preference, but preference is a thing, particularly if you get to slightly bigger numbers or involve professional money.

This would be venture capitalists or private equity groups. The first sort of fundamental thing that you get with preferred is that you are in front of the line in terms of getting paid out. So, you’re preferred. When there are dividends, you get first. If the dividends are enough to pay everybody something, then all is good. If the dividends are not enough to pay, everybody preferred gets paid, common doesn’t get paid.

There have been situations where preferred got their money and common got nothing. And that happens all the time in the case of dividends. And normally there is a dividend rate on preferred shares. Not always, but many times there are, particularly if you’re a cash flow positive business, they might say, we’re going to put the preferred shares in, and we’re going to get an 8% dividend rate or 7% dividend rate. It won’t look like bank debt. It will be more expensive than bank debt, but it is different than debt because you don’t have all the covenants and you don’t have to talk to the bank, but it does come with some other things you need to talk about. But dividends are one thing. And usually, that’s in cash on an annual basis.

Cumulative Preferred Stock

You want to grow the business; we want you to have the cash to grow the business to make this thing more valuable for all of us. And so they’ll do what’s called cumulative preferred stock or pick and pick is called payment and kind. And what that means is there are two ways – A, don’t pay me my 8% dividend; just throw it on top of the pile whenever there’s a transaction. You owe me what I put in plus my 8% for whatever number of years you didn’t pay me. So my 1 million turns into $1.2 million because you owe me some interest that you’ve never paid me, and I was okay with that, but I’ll get paid when we saw the company. Or B – payment inkind or pick, when people talk about picking the interest, you may have heard that phrase before. That means putting it at the end, right? Payout at the end. The other way it’s done is they go, look, we’ll pick it, and you can pay me in more shares. But the idea of compounding interest and the impact on their value versus your value, particularly if you don’t sell quickly, like, let’s say 3, 4, 5 years, you’re going be shocked at how much you owe your preferred shareholders when the time comes.

Non-cumulative Preferred Stock

There is also a bit rarer preferred, which is non-cumulative. Non-cumulative means if we can’t pay you for one year of your dividend, then it just goes away, and we don’t owe it to you. The other thing you get is in the case of preference, when there’s a distribution of assets, meaning we sold the company or we got a big payout or something, debt goes first, but then second is the preferred shareholders, and then third are the common shareholders in terms of who gets paid.

Cumulative Participating Preferred

It accumulates interest if there is any; most of the time, they do what they call participating preferred; when you’re not going to flow any cash, there aren’t going to be any dividends. So there’s no ongoing payment to them. So they are going to get it all on the backside. So it’s going to be juicy for us if we do that. And what that means is they participate in the up. Not only do they all get all of their cash off the table, but they also participate in the upside that has been created while you use their cash participating preferred.

For examples of preferred stock and more from Jim on this topic, listen to the complete episode of The Lazy CEO Project.

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