Preferred Equity vs Common Equity: Key Differences

When it comes to investing in companies, there are primarily two types of equity that investors can hold: preferred equity and common equity. Each offers different levels of return, security, and risk, making them suitable for different types of investors and investment strategies. In this article, we’ll explore the key differences between preferred equity and common equity, covering aspects such as dividend distribution, voting rights, risk, return potential, and more.

1. Ownership and Claims on Assets

Preferred Equity:
Preferred equity represents a class of ownership in a company, but with certain preferential treatment over common equity. Preferred shareholders have a higher claim on the company’s assets and earnings than common shareholders. In the event of liquidation (i.e., if a company goes bankrupt), preferred shareholders are paid before common shareholders. However, their claims come after creditors, bondholders, and other liabilities have been settled. While they hold a claim to the company’s assets, it’s not as strong as that of debt holders.

Common Equity:
Common equity represents ownership in the company and typically carries voting rights. Common shareholders are considered the last to be paid in the event of a company’s liquidation. Creditors, bondholders, and preferred shareholders get their payouts first. As a result, common shareholders assume a higher level of risk compared to preferred shareholders. However, they also enjoy the full upside potential of the company’s success.

2. Dividend Priority and Payment Structure

Preferred Equity:
One of the most notable features of preferred equity is its dividend priority. Preferred shareholders are entitled to receive dividends before common shareholders. These dividends are typically fixed, meaning that preferred shareholders receive a set amount per share, regardless of the company’s performance. The fixed dividend makes preferred equity an attractive option for conservative investors looking for a steady income stream. However, the fixed nature of dividends means that preferred shareholders usually have limited potential for capital gains.

Common Equity:
Common shareholders are not guaranteed dividends. If the company decides to pay dividends, common shareholders receive them after preferred shareholders have been paid. Dividends for common equity are variable and can fluctuate depending on the company’s earnings, profitability, and board decisions. This makes common equity riskier in terms of dividend income, but also offers greater potential for higher returns if the company performs well.

3. Voting Rights and Control

Preferred Equity:
Preferred shareholders typically do not have voting rights. This means they have no say in major corporate decisions, such as electing the board of directors or approving mergers and acquisitions. The lack of voting rights makes preferred equity more of a passive investment, where investors are primarily concerned with the fixed dividend and the potential for asset protection in case of liquidation.

Common Equity:
Common shareholders typically have voting rights, which allows them to participate in company decisions. These include electing the board of directors, voting on mergers and acquisitions, and influencing the direction of the company. Common shareholders often have the power to influence corporate governance and strategic decisions, giving them more control over the company’s operations and future direction. However, the extent of voting power depends on the number of shares held and the structure of the company’s voting system.

4. Risk Profile

Preferred Equity:
Preferred equity carries less risk than common equity, but it still involves some degree of risk. Preferred shareholders are paid dividends before common shareholders, and in the case of liquidation, they have a higher priority claim on the company’s assets. However, preferred equity is still subject to the company’s financial health. If a company does poorly, even preferred shareholders might not receive their dividends, especially in difficult financial conditions. Additionally, preferred stock typically has a lower growth potential compared to common stock.

Common Equity:
Common equity carries a higher risk than preferred equity, as common shareholders are the last to be paid in case of liquidation. The value of common equity is tied closely to the company’s performance. If the company thrives, common shareholders benefit from significant capital gains and increasing stock prices. Conversely, if the company performs poorly or faces bankruptcy, common shareholders could lose their entire investment. While the risk is greater, the potential for higher returns is also much greater.

5. Return Potential

Preferred Equity:
Preferred equity is generally seen as a stable investment. Preferred shareholders typically receive a fixed dividend, which provides a predictable return. This stability appeals to income-focused investors, such as those seeking consistent cash flow or those in retirement. However, preferred shareholders have limited upside potential. If the company performs exceptionally well, preferred shareholders do not benefit from capital appreciation to the same extent as common shareholders.

Common Equity:
Common equity offers greater potential for growth compared to preferred equity. As a common shareholder, you are entitled to the full upside potential of the company’s performance, including the appreciation in stock price and any dividends that might be paid. If the company is successful, common shareholders can see significant capital gains. However, the risk of loss is also greater since common equity is the last in line to be paid during liquidation.

6. Similarity to Bonds

Preferred Equity:
In some ways, preferred equity is similar to bonds. Both are considered income-generating investments, as they provide regular cash distributions (dividends for preferred equity and interest payments for bonds). The fixed nature of the dividend makes preferred equity more predictable, much like a bond’s fixed interest rate. However, while bonds are debt instruments and preferred equity is a form of equity ownership, the income characteristics of preferred stock make it behave somewhat similarly to bonds.

Common Equity:
Common equity, on the other hand, behaves more like an ownership stake in the company, rather than a fixed-income investment. The returns on common equity are tied to the company’s overall performance and are not guaranteed. Common shareholders are exposed to both the risks and rewards associated with the company’s business performance, which contrasts with the predictable income provided by preferred equity or bonds.

7. Liquidity and Marketability

Preferred Equity:
Preferred shares may be less liquid than common shares, especially if the company does not trade publicly or the market for preferred stock is smaller. However, in the case of large, publicly-traded companies, preferred equity is typically quite liquid and can be bought or sold on the stock exchange like common equity.

Common Equity:
Common shares are typically more liquid than preferred shares, especially in companies that are publicly traded. The large number of buyers and sellers in the market means common equity is often easier to trade and has a more active market.

8. Tax Implications

Preferred Equity:
Dividends paid on preferred equity are often subject to different tax treatment than those paid on common equity. In many jurisdictions, the dividends paid on preferred equity may be taxed at a lower rate than the dividends paid on common stock, making preferred equity an attractive investment for tax-conscious investors.

Common Equity:
Dividends on common equity are usually taxed at a higher rate than those on preferred equity. However, common equity may provide greater long-term capital gains, which may be taxed more favorably depending on the investor’s tax situation.

Conclusion

Preferred equity and common equity are two distinct forms of ownership in a company, each with its own set of advantages and disadvantages. Preferred equity provides more stability, priority in dividends, and a lower risk profile, but it limits potential growth and does not offer voting rights. Common equity, on the other hand, offers the potential for higher returns and greater control over company decisions, but it comes with higher risk and no dividend priority. The choice between preferred equity and common equity depends largely on an investor's risk tolerance, income requirements, and investment goals.