Corporations raise money for operations from investors through a combination of equity and debt financing. Equity financing sells individual investors ownership in the company in exchange for money. Debt financing offers investors an interest payment in exchange for the use of their money, under an agreement that the principal of the loan will eventually be repaid. Stocks are the traditional vehicles for equity financing, while bonds are the traditional debt financing vehicle. Preferred stock is a hybrid security that has some of the characteristics of an equity instrument and some of the characteristics of a debt instrument. The dual nature of preferred stock causes it have many of the same advantages and disadvantages to the corporation as long-term debt.
Preferred stock pays investors a guaranteed dividend that operates like an interest payment on long-term debt. The dividend rate is typically set using the same financial indicators as an interest rate. Typically, a corporation can defer dividends on preferred stock but must eventually make the payment, much in the same way as a corporation can make a late interest payment but must eventually catch up. The obligation in both instances never goes away.
Dividend payments on preferred stock must be paid before common shareholders can receive dividends. Preferred stockholders have a preferential claim on a corporation's assets and profits that is substantially similar to the preference of a creditor of a long-term debt obligation. If a corporation is liquidated, creditors and preferred shareholders are paid before regular owners with common stock.
Preferred stockholders typically do not have voting rights in the corporation. Although they do own equity that can appreciate, their functional rights are similar to the rights of long-term debt creditors. Creditors have a claim on corporate assets but cannot control the way a company does business. Likewise, preferred stockholders must sit and watch their investment in action without any control over business affairs.
Long-term debt is strictly defined as a loan that has a maturity date that exceeds the current operating year. Typically, however, long-term debt can have a loan term that is 10, 15 or 20 years down the road, or more. The important characteristic of long-term debt is that it is not due currently or in the immediate future. The corporation can use the money without worrying that the principal needs to be paid back. Likewise, preferred stock offers that same freedom of financing without having to worry about paying the money back in the near term. Preferred stock has no maturity date. The stock does represent an ownership interest in the company and can appreciate. Preferred stockholders can hold their stock forever without trying to recoup the principal investment.
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