Understanding Preferred Stock vs. Common Stock: Dividends and Company Obligations
The terms 'preferred stock' and 'common stock' refer to different types of equity shares in a company. Each type of stock comes with distinct rights and responsibilities when it comes to dividends and other financial benefits. Understanding these differences is crucial for investors and stakeholders. This article will delve into the key distinctions and explore the obligations of companies in terms of dividend payments.
What is the Difference Between Preferred Stock and Common Stock?
Preferred stock and common stock are both equity securities in a company but are treated differently with respect to dividend payments and other financial benefits. Preferred stockholders have a higher claim to dividends and assets in the event of a company's liquidation, whereas common stockholders have a lower claim and more exposure to the company's risks.
The key difference lies in the priority paid to preferred shareholders during dividend distributions and in situations where the company faces financial difficulties. Preferred shareholders typically receive their dividends before common shareholders and are guaranteed to receive a fixed dividend if the company is in a position to pay dividends. Even if a company does not have enough profits to distribute dividends to common shareholders, it must still pay preferred dividends in arrears, which is a key obligation of the company under the terms of the preferred stock.
This differs from common shareholders, who do not have a guaranteed dividend. The dividend for common stock is determined by the company's board of directors and is not guaranteed. In fact, common shareholders often benefit from a larger share of any remaining profits after preferred dividends have been paid, which is referred to as surplus revenue. This allows common shareholders to participate in the company's growth and success to a greater extent than preferred shareholders.
Dividend Obligations of Public Companies
The obligation for a public company to pay dividends on preferred stock is a critical aspect of investor rights and requires strict adherence. Companies are legally bound to pay dividends on preferred stock if they are in a position to pay dividends. If the company does not have sufficient funds to pay dividends, it must carry forward the unpaid dividends into the next dividend period. If the company later generates enough profits to pay dividends, it is required to pay the accumulated dividends before paying any dividends to common shareholders.
This is governed by the terms of the preferred stock, which typically specify a fixed dividend rate and a required payment schedule. Companies must also face the consequences if they fail to meet these obligations, as they could be at risk of default or legal action by preferred shareholders.
Moreover, the impact of preferred stock on dividend obligations is not limited to the current distribution period. If a company enters a phase of financial stress or even declares bankruptcy, preferred shareholders have the priority claim to any remaining assets, including potential future dividends. This is in stark contrast to common shareholders, who may not receive anything in such scenarios.
Rights of Preferred and Common Shareholders
While preferred shareholders have a higher claim to dividends and assets, common shareholders have additional rights that can positively impact their investment over time. Preferred shareholders are entitled to a fixed dividend rate as specified in the terms of the preferred stock. This fixed dividend rate is often expressed as a percentage of the par value of the preferred stock.
Common shareholders, on the other hand, do not have a guaranteed dividend but are entitled to participate in the surplus revenue of the company. If a company generates more profit than necessary to cover the preferred dividends, the remaining profits are distributed to common shareholders. Additionally, common shareholders have the right to receive bonus shares if a bonus share scheme is declared, participate in a rights issue, and receive stock splits.
The board of directors has the authority to decide on the distribution of surplus revenue, which can lead to significant growth for common shareholders. Common shareholders also have the right to voting in shareholder meetings, although the specific voting rights may vary based on the company's articles of incorporation.
Conclusion
Preferred stock and common stock offer distinct benefits and obligations to investors, particularly in terms of dividend payments and other financial benefits. While preferred stockholders have a higher claim to dividends and assets, common stockholders have the potential for greater returns through participation in the company's surplus revenue and growth.
Understanding the nuances of preferred and common stock is essential for investors to make informed decisions. Companies are obligated to adhere to the terms of preferred stock, ensuring that preferred shareholders receive their fixed dividends and any unpaid dividends are carried over and paid at a later date.
Ultimately, the choice between preferred and common stock depends on the investor's risk tolerance, dividend preferences, and long-term investment goals. Whether an investor chooses to focus on the stability of fixed dividends or the potential for higher returns through common stock, a thorough understanding of the differences can lead to better investment outcomes.