Understanding the Risk of Preferred vs Common Stock

Understanding the Risk of Preferred vs Common Stock

by Jan 23, 2024Business, Entrepreneur, Growth, Private Equity, Raising Capital

When securing funding to fuel your business expansion, the conventional practice involves issuing common stock. This is the customary avenue through which you would offer shares to individuals such as your parents, uncle, or friends and neighbors who are interested in contributing to the financial support of your company’s growth.

But, if you turn to professional investors like a private equity firm to raise money, they’re going to ask for something called preferred instead of common stock.

While that has also become standard practice, you, as the owner and founder of the business, need to understand the difference between common and preferred stock because you can find yourself facing challenges or outcomes you never expected.

1. Dividends

If your company is generating a positive cash flow, then your preferred stockholders will expect to be paid an annual dividend–which could range from 6 percent to 8 percent based on the size of their shares. These dividends, which you can also think of as an interest payment of sorts, are paid out before you can take any profits out of the business. It’s an obligation you have to your preferred shareholders. Sometimes, your shareholders are willing to defer those payments–a practice called payment in kind, or PIK–until you sell the company in the future. When you PIK the dividend, as it’s called, the interest stacks up over time. When you sell, you then owe your shareholders all that interest on top of the money they will earn from their shares, just like the common shareholders.

One practice to watch out for is when shareholders request their PIK be paid in more preferred stock or equity. When you do this, their interest will multiply and compound over time and turn into more equity, diluting the common shareholders every year. If your investor stays with the business for five years and earns interest at 8 percent per year, they will almost double their equity position.

2. Liquidity Preference

In earlier-stage companies, paying dividends might not be realistic. That might mean preferred shareholders will request what’s known as liquidation preference instead. This means that when you sell the business, your investors will get all the money they put into it before anyone else gets paid. For example, if investors take a 10 percent stake in your business and it sells for $100 million, they get their $10 million (plus the PIK if there is one) before you or anyone else gets any money. They then participate in the equity payout just like all other shareholders. This practice is designed to protect the investor’s downside. It’s a bit of financial engineering that ensures that if anything goes wrong in the business, they get paid first.

That example is for a one-time liquidation preference. There are some deals with higher rates, such as 1.25x, or even as high as 2x. Using the example above, the preferred shareholders would get $20 million back from their $10 million investment and then participate based on ownership with the common shareholders.

I’ve seen this go badly in some companies. In one case, investors in a company had about $100 million of preference in a company that was projected to sell for $300 million. But conditions for the company deteriorated over the next few years and it was forced to sell for just $40 million. Guess what happened? The preferred investors took all the proceeds as their preference, while the founder and other common shareholders got nothing.

3. Information Rights

Once you have preferred shareholders, you will need to report to them quarterly about the financial performance of the company. That might also include sending a monthly or quarterly letter from the CEO. Most entrepreneurs are not used to doing this. It requires discipline and a system to pull it off with regularity.

There’s also the additional catch that many professional money investors employ teams of analysts who will ask you questions you need to answer. Those questions can become very detailed and require lots of time to answer. That forces some CEOs to assign a member of their finance team on a part-time basis to address many of these questions.

4. Board Oversight

If you don’t have a board already, you will have one once you bring on preferred shareholders. That board will then use the board environment to question management and try to influence policy and strategy. Preferred shareholders might also insist on naming 25 percent of the board members to ensure they maintain influence over the company’s direction.

5. Changes to the Operating Agreement

Beyond having influence through the board, preferred shareholders might also put elements in place that allow them to directly influence or say no to lots of things a CEO might want to do in the business. Things such as issuing more stock, raising money, changing executive compensation, or even selling the company will require approval by the preferred shareholders. They have a veto right over everything if they want to use it. We call these items negative control provisions since they can’t make something happen, but they can stop it. This capability has frustrated more than a few entrepreneurs.

Go In With Eyes Open

Raising money through issuing preferred stock can be an effective way to grow a business. But too many entrepreneurs and CEOs don’t fully understand that the game can be rigged against them if they don’t go into a deal with their eyes open. It’s important to remember that preferred stockholders will do everything they can to ensure they come out ahead and get their money back plus some. They can also bring time pressure to sell a business that you might not expect because of their obligations to their investors if they are a private equity company. While they might say their interests are aligned with your own, they’re not. So, do your due diligence ahead of time and know what can go wrong if you don’t.