If you’re starting up a new enterprise and don’t have sufficient funds for the initial investment, you could turn to a bank or other credit institution for a business loan, but start-up loans are rare because the risk to the investor is difficult to measure. They also carry payment obligations that may be difficult to meet in the early stages when your business has its most significant cash outlays. Preferred stock offers a way to attract investors by mitigating their risks, and it offers you the flexibility to defer dividend payments without penalties. It does, however, come with strings attached.
Preferred stock pays a fixed dividend regardless of whether the value of shares increases or decreases. If your business is unable to pay this dividend in a given year, the amount due remains on the record and the company must pay it, along with new dividend earnings, before common stock shareholders can collect anything. For example, say your company committed to a 4 percent dividend, but the initial start-up costs make it impossible for the company to pay these dividends in the first year. A shareholder who owns $1,000 worth of your preferred stock would get the $40 your company owes from the first year plus an additional $40 in the succeeding year. If the company is unable to pay for the first three years, the shareholder would get $160 in the fourth year.
Liquidation or Sale
If your company fails, or if you sell it, you must use funds from the sale or liquidation to pay any bondholders first. Then, preferred stockholders get their initial investment back before the common stockholders receive any funds. Preferred stockholders are partial owners of the company, so if there is more than enough money to repay their initial investment, they may choose instead to share in the proceeds of the sale or liquidation according to the percentage of the company that they own. For example, if Ms. Smith purchased 1,000 of the 100,000 shares that your company issued and she purchased them as preferred stock at $50 per share, she could choose to recoup her initial $25,000, plus any unpaid dividends, or she could elect to take 1 percent of the funds generated by the sale of the company or its assets.
Rights and Voting Privileges
Preferred stockholders might seem like a blessing when you’re looking for start-up capital or funding for an expansion, but this money comes with significant strings attached. Preferred stockholders do not hold the normal voting rights of common stockholders, but they usually get a seat on the company’s board of directors and have the right to information about the company’s finances that other stockholders do not receive. They also have first right of refusal for the purchase of any common stock that you might sell, often at a preferential rate that you negotiate as part of the preferred stock sale.
For a start-up company, preferred stock can be a lot easier to obtain than a loan or bond funding. Preferred stock also may be the only viable fund-raising option for a company that already has significant debt. Unlike payments on loans or bonds, deferred dividend payments on preferred stocks do not accrue interest or other penalties and you face no risk of foreclosure.
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