What is preferred equity? Preferred equity is a portion of capital stock that can consist of any combination of characteristics not possessed by common equity, including common stocks of equity and an unsecured debt instrument, and is usually regarded as a preferred equity instrument. It differs from common equity in that it does not carry the guarantee of repayment by the owner. The distinction between equity and preferred equity should be noted in light of the different ways in which debt is classified in a venture.
Common equity carries the guarantee of repayment of principal and interest. That is, if the value of the equity or the value of the dividend payments is less than or equal to the value of the outstanding common equity, the difference between the two values is termed preference. Alternatively, if the value of the common equity is more than or equal to the value of the preference, then the difference between the two is termed dividend income. Preference may also be referred to as premium or dividend over the market value of the enterprise.
One distinguishing feature of preferred equity is that it is not exchangeable between corporations. If a corporation does not own a preferred stock and decides to purchase Preferred Stock from another corporation, then the purchase will be considered a secondary transaction and the shareholders of the latter corporation will receive their preference (preference plus their initial investment) in the new corporation. This is known as a ‘follow-on’ purchase. A shareholder who is the designated holder of such an option will own the new corporation at the time it is created and will receive a percentage of the issued and existing stock (the ‘premium’) plus his investment in the new corporation. The effect of this is that the purchaser’s preference plus his original investment will be zero in the new organization.
In contrast, common equity (the stock of an ordinary corporation) is exchangeable between different companies on the basis of their financial performance. A common stockholder has no right or obligation in relation to the management of a company and has only the right to dividends based upon the nature of the business. However, he can exercise the option to purchase Preferred Stock in the ordinary share account of the Company. Under these circumstances, if the Company’s value increases for some reason (even though there are no securities underlying the Preferred Stock), then the Preferred Stock will be repaid to him in cash. If the market price of the Company’s common stock drops, then he is entitled to receive his interest in the Preferred Stock in proportion to the value of his Preferred Stock.
Most businesses operate in a flexible manner with regard to equity. A company could buy common equity in order to finance its business venture but could also opt for preferred equity. There are advantages and disadvantages associated with each type of equity strategy. These differences are reflected in the financial accounting measures used to record the equity results.
A company’s preferred equity is referred to as the common equity. Under the equity options and funding provisions of various investment funds, a company can sell part of its common equity to raise additional capital. This transaction is known as an acquisition. It is seen as an attractive option because of the low cost and fast distribution. It is also a convenient way of raising funds when the need arises.
On the other hand, a company’s preferred equity is often referred to as the underlying common equity. Under these circumstances, a company can choose to either use the funds acquired through the acquisition or use the same funds to pay back its debts. A preferred stock will not be included in the debt or equity balance sheet of a company unless and until it is sold or disposed. However, before a company decides to sell its preferred equity, it must first make sure that its shares on the open market are trading at a price which it can secure from other bids/concentrations.
A company must always remember that it needs to follow the rules of equity. Companies must never forget that they are liable to pay taxes even if their debt is considered surplus. Companies cannot also use their assets to finance their own debt. There are many more types of what is preferred equity extraction and there are also several other areas of study.