Preferred Shares vs. Common Shares: Everything You Should Know

What Are Preferred Shares?

Preferred shares ("preferreds") are hybrid securities with both equity and fixed income characteristics. Similar to equity securities, preferred shares represent owner's equity, usually have no maturity date, and are recognized on the equity side of the company's balance sheet. Preferred shares have priority over profit distribution and company assets. And their risk is small. However, preferred shareholders don't have the right to vote or stand for election on corporate affairs. Preferred shares cannot be redeemed by shareholders but can only be redeemed by the company through the redemption terms of preferred shares. Generally, preferred shares have a predetermined dividend yield, while the scope of equity is minimal. The creditor's right to preferred shares is prior to that of ordinary shares and inferior to that of creditors.

Types of Preferred Shares

1. Cumulative Preferred And Non-Cumulative Preferred

Cumulative preferred shares mean that when the company issues shares, it promises to pay dividends to shareholders of a preferred share. If the company's operating conditions are poor and it cannot issue dividends, the accumulative special shares can be accumulated for future payment, usually accumulating until the following year. In short, it is a preferred share that the company accumulates unpaid dividends in previous business years and pays them together with the profits of future business years.

Non-cumulative preferred shares refer to preferred shares that distribute dividends according to the profits of the year and do not make up for the accumulated dividends that have not been fully paid. In short, no dividends were paid in the current period, and no dividends will be reissued in the future. Therefore, when buying such preferred shares, special attention should be paid to the profitability of the company.

Therefore, generally speaking, cumulative preferred shares have greater advantages for investors than non-cumulative preferred shares.

2. Participating Preferred Shares And Non-participating Preferred Shares

Participating preferred shares offer holders an opportunity to receive additional dividends if the company meets predetermined revenue, profit, or profitability goals. Investors who purchase this type of preferred shares receive a fixed dividend regardless of the company's performance. Therefore, participating preferred shares refer to the preferred shares that can receive the fixed dividends of the year according to the regulations and have the right to participate in the company's profit distribution with ordinary shareholders. Therefore, investors will receive common share dividends & special share dividends.

Non-participating preferred shares refer to preference shares that only receive dividends according to the prescribed dividend rate and do not participate in the company's profit distribution. In fact, the vast majority of special shares are not allowed to participate. After all, the issuance of special shares that can be participated in is known to be harmful to the interests of original shareholders, but sometimes the company will issue such preferred shares in order to avoid malicious mergers and acquisitions by others.

Generally speaking, participating preferred shares are more beneficial to investors than non-participating preferred shares.

3. Convertible Preferred Shares And Non-convertible Preferred Shares

Convertible preferred share is an increasingly popular type of preferred share. Common share is highly liquid, but the preferred share is very illiquid, and sometimes there is a risk that it will not be sold. Convertible preferred share is a preferred share that the holder can convert the preferred share into common share or corporate bonds under certain conditions. Conversions can occur at any time the investor chooses, regardless of the market price of the common share. Share conversion is a one-way transaction; investors cannot convert ordinary shares back to preferred ones.

Non-convertible preferred share refers to preferred shares that cannot be converted into common shares or corporate bonds.

4. Callable Preferred Shares And Non-callable Preferred Shares

Callable preferred shares refer to the preferred shares that the issuing company can call back at a certain price. Most of the special shares are redeemable. The company will agree with the shareholders of the special shares on a date after which the company will have the right to recall the preferred shares according to the face value at the time of issue (usually 25 USD).

Non-callable preferred shares refer to the preferred shares that the issuing company has no right to recall from the shareholder.

Advantages And Disadvantages of Preferred Shares

Advantages 

Preferred shares have conversion rights

As we said above, there are convertible and non-convertible types of preferred shares. Generally, common shares are highly liquid. However, the liquidity of preferred shares is very low, and sometimes there is a risk that they cannot be sold. At this time, convertible special shares can convert special shares into common shares, which can reduce liquidity risk.

Preferred shares can protect capital

Taking special shares issued in the United States as an example, the par value of special shares is 25 US dollars. After five years of issuance, the issuing company can redeem the preferred shares at any time. Since the buying back price of the issuing company needs to be equal to the issue price, investors who hold preferred shares until they expire will not have a profit or loss from the price difference, which means that they can recover their principal when they expire. Therefore, preferred shares have the advantage of capital preservation.

Distribute the remaining property first

When a company goes bankrupt, preferred shareholders will have priority over common shareholders in obtaining the remaining property distribution rights because preferred share is a combination of bonds and common shares. Usually, bondholders are paid first, so in the event of bankruptcy, the preferred shareholders will pay first before the common shareholders get anything.

Lower share price volatility 

If the preferred shares do not have the right to be converted into common shares, their nature will be close to that of a bond, and most of the time, the share price will not change much. Even if the common shares soar, when the company grows, it has nothing to do with the preferred shares. When the company falls sharply, as long as it does not go bankrupt and does not pay the interest principal, the value of the preferred shares will not change much.

Disadvantages

Investors must pay attention to five significant risks when buying preferred shares:

1. Interest rate risk

The risk to be aware of when investing in preferred shares is the interest rate risk of raising or lowering interest rates. The Federal Reserve will raise interest rates, and hot money will flow to lower-risk U.S. bonds, which may sell preferred shares. Therefore, special shares have the characteristics of bonds, and investment in special shares should pay attention to the policy of raising and lowering interest rates. Prices will fall as interest rates rise, and this year raised interest rates, which will lower the price of preferred shares.

2. Credit risk

Due to poor management or credit rating problems, the issuing company may not pay dividends.

3. Recall risk

If the issuing company redeems the preferred shares in advance, the investors will have the risk of reinvestment, and the subsequent dividends will not be received. Most special shares come with a call option (redemption right). When the deadline is reached, or a certain condition is met, the company has the right to redeem at a redemption par amount of $25 per share. Therefore, when buying special shares, it is important to pay attention to the time when the company can buy them back (redeem). In short, early redemption is usually when the company achieves the purpose of issuance and does not want to continue to pay dividends, it will redeem early to investors, but the conditions for early redemption will be set at the time of issuance. Be sure to look clearly before investing.

4. Exchange rate risk

Some foreigners want to invest in preferred shares of other countries or regions, which may result in exchange rate losses.

5. Liquidity risk

Both common shares and preferred shares can be bought in general securities companies, but due to the small number of preferred shares, not every company has preferred shares, and holders often treat them as bonds to receive interest. Therefore, preferred shares are usually relatively seldom circulated in the market. In short, preferred shares are very similar to convertible bonds. There will be a lot of them at the beginning of the issuance, but they will become less and less in the future, and it is difficult to sell them if you want to sell them. There is usually still trading volume within one month of preferred share listing, but after more than one month or even more than three months, the purchase order will be much less. The trading volume of preferred shares is less than that of common shares. If there is an urgent need to sell shares, there may be cases where transactions cannot be made. It is recommended that before buying preferred shares, priority should be given to selecting more liquid and popular targets to avoid liquidity problems.

There are also significant differences in the holding period. Most retail investors subscribe to preferred shares for a short-term investment, and most long-term investments are life insurance and investment companies with fixed income needs. Due to liquidity considerations, brokers may choose medium-term (about half a year to one year) investments.

Special reminder: General investors who want to buy preferred shares should be aware that the share price will fall below the underwriting price shortly after the issuance, and the trading volume will also shrink significantly. If you don't want to receive interest for a long time, it is recommended to hold it for 1 to 3 months and dispose of it as soon as possible. Otherwise, you may be locked up due to poor liquidity and cannot be sold later.

What Are Common Shares?

Common shares are the most common, the most important, and the largest type of share issued by a company limited by shares. If a company only issues a kind of share, the share is a common share, and what we usually refer to as company shares usually refers to common shares. A common share is a type of share that changes with changes in corporate profits. If a company performs well, the value of the common share increases, but if the company performs poorly, the value of the share also decreases.

Types of Common Shares

A company limited by shares may issue different classes of common shares.

1. According to whether the share is registered or not, it can be divided into registered shares and bearer shares:

Registered shares are shares in which the name or name of the shareholder is recorded on the face of the share. Except for the shareholders recorded on the share, other people are not allowed to exercise their equity, and the transfer of shares has strict legal procedures and formalities, and transfer of ownership is required. China's "Company Law" stipulates that shares issued by promoters, state-authorized investment institutions, and legal persons should be registered shares.

Bearer shares are shares in which the names of shareholders are not recorded on the face of the shares. The holder of this type of ticket is the owner of the shares and has shareholder qualifications, and the transfer of shares is relatively free and convenient without going through the transfer procedures.

2. According to whether the share is marked with the amount, it can be divided into par value shares and no par value shares:

Par value shares are shares marked with a certain amount of money on the face of the share. Shareholders who hold such shares have rights and obligations to the company according to the ratio of the face value of the shares they own to the total face value of the company's outstanding shares.

No-par value shares are shares that do not indicate the amount on the face value but only indicate the proportion of the company's total share capital or the number of shares. The value of shares without par value changes with the increase or decrease of the company's property, and shareholders' rights and obligations to the company are directly determined by the proportion indicated on the share.

3. According to different investment subjects, it can be divided into state shares, legal person shares, and individual shares:

State shares are shares formed by investing in companies with state-owned assets by departments or institutions that have the right to represent state investment.

Legal person shares are shares formed by corporate legal persons investing in companies with their disposable properties according to law. Or the shares created by public institutions and social organizations with legal person qualifications investing in the company with the assets allowed by the state to be used for business.

Individual shares are shares formed by social individuals or internal employees of the company who invest in the company with the personal legal property.

4. According to different issuers and listing regions, shares can be divided into A shares, B shares, H shares, and N shares：

A shares are for individuals or legal persons in mainland China to buy and sell. The par value is marked in RMB and subscribed and traded in RMB.

B-shares, H-shares, and N-shares are exclusively for foreign investors and investors from China's Hong Kong, Macao, and Taiwan regions. The par value is marked in RMB but subscribed and traded in foreign currencies. Among them, B shares are listed in Shanghai and Shenzhen; H shares in Hong Kong; N shares in New York.

Advantages And Disadvantages of Common Shares

Advantages

Common share is the most common form of equity investment. In venture capital, common shares investment has many advantages.

(1) Participation in management rights

Investors in common shares have the right to participate in the management of the business. After obtaining the right to participate in the operation and management of the enterprise through common share investment, investors can better understand the situation of all aspects of the enterprise to effectively prevent agency problems and moral hazards.

(2) Facilitate exit in the capital market

Common shares investment is the most favorable exit vehicle for venture capitalists. Moreover, equity transfer exits are the most commonly used exit methods for venture capital, such as IPO and M&A. Investors of other investment methods must convert their investment into corresponding common shares if they want to exit through IPO or mergers and acquisitions. It can be seen that common shares investment is the most favorable investment method for venture capital exit.

(3) Obtain voting rights

Holders of common shares typically earn voting rights, and voting rights will increase proportionally with the more shares the holder owns. The most common situation is that every share owned can get one vote. Voting rights can be used to elect board members, supervise the management and make other significant decisions.

(4) Good liquidity

Both common shares and special shares can be bought in general brokerages, but the number of common shares is relatively large. So there are more in circulation in the market.

Disadvantages

(1) Large price fluctuations

Both common shares and preferred shares have prices, and the price of the common share is closely related to the company's operating conditions. Therefore, as long as there is a business crisis in the company, the cost of common share will fluctuate greatly.

(2) Profit distribution is later than preferred shareholders

Shareholders of common shares are entitled to dividends from the company's distribution of profits. Dividends on common shares are not fixed and are determined by the company's profitability and distribution policy. Ordinary shareholders must be entitled to dividend distribution rights after preferred shareholders have received fixed dividends.

Preferred Shares vs. Common Shares: What Are The Differences?

1. Different Rights For Company Management

Ordinary shareholders can fully participate in the company's operation and management and enjoy the rights of asset income, participation in major decision-making, and selection of managers. Shareholders of preferred shares generally do not participate in the daily operation and management of the company and generally do not participate in voting at the general meeting of shareholders. But in some exceptional cases, for example, if the company decides to issue new preferred shares, preferred shareholders have voting rights. 

At the same time, in order to protect the interests of preferred shareholders, if the company fails to pay dividends within the stipulated time, the preferred shareholders shall resume their voting rights as agreed; if the company pays the dividends owed, the restored voting rights of preferred shares shall be terminated.

2. The Order of Distribution of Profit And Surplus Property Is Different

Compared with ordinary shareholders, preferred shareholders have priority in the distribution of the company's profits and remaining assets.

3. Different Risks And Benefits

The dividend income of ordinary shareholders is not fixed. It depends not only on the company's profit status in the year but also on the specific distribution policy of the year. The company will likely decide not to distribute in the year. The dividend income of preferred shares is generally fixed, especially for preferred shares with mandatory dividend clauses; as long as the company has profits that can be distributed, it should be paid to preferred shareholders according to the agreed amount. The fixed dividend yield reduces the risk of the preferred share; however, when the company is profitable, the preferred share is less profitable than the common share, so the common share is characterized by higher risk and higher return.

4. The Performance of Withdrawing Shares Is Different

Common shareholders cannot request to withdraw their shares but can only cash out in the secondary market; if there is an agreement, preferred shareholders can sell their shares back to the company according to the contract.

Considerations Before Choosing Common or Preferred Shares

Here are some key points to consider when deciding whether to purchase common or preferred shares:

1. The Length of Investment Time

If you're looking for an investment that will pay off in the short term, preferred shares can be a good choice because they offer little and steady dividend income without the opportunity for massive growth. On the other hand, if you're looking for an investment that increases in value the longer you hold it, the common share dividend yield may be more critical in the long run if the share price rises.

2. Risk Considerations

Common shares are riskier investments. Preferred shares are less risky than common shares because they do not move with the market, and investors receive a higher priority in bankruptcy payments.

Preferred Shares vs Common Shares: Final Thoughts

So, you may have decided so far which investment tool to choose, but before drawing any conclusions, first consider the following factors, namely long-term and short-term goals, risk tolerance, growth potential and liquidity needs. With regard to growth, common share has advantages over preferred share, but preferred share is less risky than common share when it comes to risk.