What are the reasons to issue preferred stock instead of common stock?

2 Attracting Diverse Investors

Another reason to issue preferred stock is to attract diverse investors who have different preferences and risk profiles. Preferred stock can appeal to investors who seek a steady income stream and lower volatility than common stock. Preferred stock pays a fixed dividend that is usually higher than the dividend of common stock, and it has priority over common stock in receiving dividend payments and assets in case of liquidation. Therefore, preferred stock can offer more stability and security to investors who are risk-averse or income-oriented. On the other hand, preferred stock can also appeal to investors who seek higher returns and growth potential than debt. Preferred stock has an equity component that can appreciate in value if the company performs well, and it can be converted into common stock under certain conditions. Therefore, preferred stock can offer more flexibility and upside potential to investors who are risk-tolerant or growth-oriented.

3 Improving Financial Ratios

A third reason to issue preferred stock is to improve the financial ratios that measure the company's leverage, liquidity, and solvency. Preferred stock is classified as equity on the balance sheet, which means that it does not increase the company's debt or interest expenses. This can improve the company's debt-to-equity ratio, which shows how much debt the company uses to finance its assets, and its interest coverage ratio, which shows how easily the company can pay its interest obligations. These ratios are important for the company's creditworthiness and borrowing capacity. Additionally, preferred stock can improve the company's current ratio, which shows how well the company can meet its short-term liabilities with its current assets. Preferred stock does not affect the company's current assets or liabilities, unlike debt or common stock, which can reduce the company's cash or increase its accounts payable. A higher current ratio indicates a better liquidity position for the company.

4 Reducing Tax Liability

A fourth reason to issue preferred stock is to reduce the tax liability of the company and its investors. Preferred stock dividends are paid out of the company's after-tax earnings, which means that they are not tax-deductible for the company. However, preferred stock dividends are taxed at a lower rate than ordinary income for the investors, which can make them more attractive than interest payments from debt. Furthermore, some preferred stock dividends may qualify for the dividends received deduction (DRD), which allows corporations to deduct a percentage of the dividends they receive from other corporations. This can reduce the double taxation of corporate income and increase the after-tax return for the investors.

5 Enhancing Corporate Governance

A fifth reason to issue preferred stock is to enhance the corporate governance and accountability of the company. Preferred stock can be used as a defensive mechanism against hostile takeovers or activist shareholders who may try to gain control or influence over the company. By issuing preferred stock with special rights or provisions, such as super-voting rights, cumulative dividends, or redemption features, the company can protect its interests and deter unwanted interference. Alternatively, preferred stock can be used as an incentive mechanism to align the interests of the management and the shareholders. By issuing preferred stock with performance-based or convertible features, such as adjustable dividends, participation rights, or warrants, the company can reward the management and the shareholders for achieving certain goals or milestones.