A preferred stock is of two types – participating and non-participating. Let’s learn about the basic difference between the two and the pros and cons of investing through these stocks.
When a company enters into a business, a significant amount of money is invested in it by its founders. This amount of money is referred to as “stock” of the company. The stock of a company is divided into shares and the total number of shares of a company is declared when the company is formed. People who want to invest in a particular company, can do so by buying shares or stocks of that company. There are two types of stocks pertaining to a business entity –
- Common stock
- Preferred stock
The basic difference between common stock and preferred stock is that common stock holders can contribute in corporate decisions through their voting rights, while preferred stock holders do not enjoy voting rights, but, are entitled to receive dividend before it is distributed to other shareholders. In case of inability of the company to pay dividends to the holders, they have the right to forcefully liquidate the company. Preferred stock is of two types –
According to Farlex Financial Dictionary a preferred stock is “Stock in a publicly-traded company without voting rights, but otherwise with more rights than common shares. These stocks receive dividends before common shares and sometimes have guaranteed dividends, while common shares only receive the leftovers. Preferred stocks also have a prior claim on capital in the event of liquidation; if the company is liquidated, all preferred shareholders must be paid off before a single common shareholder. Some of these stocks are convertible, which means they can be changed into common shares at a certain ratio so that even preferred shareholders without voting rights have the possibility of gaining them. These stocks tend not to appreciate as fast as common stocks”.
What is a Participating Preferred Stock?
Holders of this stock are eligible to receive the amount of money they have invested in the company and the accumulated unpaid dividends before common stock holders, in the event of liquidation. Apart from this, the holders of preferred stock along with the common stock holders, get a share while distribution of remaining assets of the company. The stock is favorable for investors in the company as they enjoy returns on low as well as high transaction value prior to common stock holders.
What is a Non-Participating Preferred Stock?
This is a type of stock in which the holders are eligible to receive the amount invested by them plus, the accumulated dividends or pro rata in liquidation proceedings, whichever is higher. They cannot enjoy their investment amount along with a share in remaining assets of the company. In case, the share of common stock holders is greater, the preferred stock holders can convert their shares to common stock by giving away their right to share the other assets of the company. This stock is favorable for the founders and management i.e., the common stock holders of the company, because after a particular transaction value, the preference on liquidation loses its significance.
Which One is Better for an Investor?
When an investor wants to invest money in a company, it is preferable to opt for the participating preferred stock as compared to non-participating type. This is because it gives a higher share to the investor in the company. In case of liquidation, the investor not only gets back his invested amount, rather gets an additional share during the asset distribution of the company. In situations when the company is sold at a premium rate, the participating preferred stock holder enjoys the returns obtained due to upside of the company.
Thus, in order to gain more from a specific investment amount, it is favorable that an investor chooses a participating preferred stock over a non-participating one in the stock market.