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March 31, 2020

The Pros and Cons of Preferred Equity Investments Equity Crowdfunding

In a business, equity represents ownership. Whether a business is in need of startup funds or is raising capital, equity crowdfunding investors can choose between common and preferred equity (also called preferred stocks or shares). The term “preferred” represents additional privileges and rights that investors get in return for their investment. (beyond owning a part of the business) In return for investing, an investor receives shares or equity that represent their ownership in the business.

The difference between these two types of investments is that certain crowdfunding investors are given preference relative to the common equity when it comes to cash flow distribution. For example, in a preferred equity structure, all net profits or cash flow are paid back to the preferred investors until they receive the return (which was previously agreed upon). Once the company pays back the preferred investors, the remaining distributions are returned to subordinate financing investors who hold common equity in the business.

Those who are looking for a higher-yielding (but steady return) may make these investments because they carry a higher potential overall return for consistent cash flow and less risk. What’s important to understand is that both forms of equity represent ownership interests in a company for third party investors, but they don’t have direct recourse to the asset and are not secured (like secured debt).

Pros and Cons of Preferred Equity

Pros 

  • Steady stream of income. Common equity investment may or may not pay dividends. Also, depending on various factors, dividend amounts vary and are typically paid on the discretion of the Board of Directors.
  • Guaranteed dividend. Preferred investments guarantee a dividend of a certain percentage of the share value.
  • Flexibility. Preferred stock owners can convert some of their preferred equity into common equity, depending on the type of preference shares.
  • Liquidation preference. In the case of company liquidation, owners of preferred equity have priority over those who own common stocks.

Cons 

  • No dividend growth and income risk. Preferred stock dividends are fixed, meaning they don’t increase over time as the company grows (unlike common stock dividends). Furthermore, preferred equity dividends are not guaranteed in case the company experiences financial difficulties. It may leave the investors stuck with shares that have neither dividends nor appreciation potential.
  • Lack of voting rights. Typically, preferred equity doesn’t grant voting rights. The holders don’t partake in a company’s decision-making process and cannot participate in the election of the Board of Directors.
  • Interest rate sensitivity. Investors usually tend to make preferred equity investments for high dividends. However, since the dividends on these investments are fixed, they are sensitive to interest rate changes – the prices of fixed income securities decline when the interest rate rises.
  • Limited upside potential. The upside potential of preferred equity investments is limited by the additional features they carry.
  • Principal risk. If the company files for bankruptcy, preferred equity investors have priority over common equity investors. However, preferred shareholders can suffer a complete loss (just like common shareholders) because it often happens that no assets are left when it’s the turn of preferred shareholders to be paid. 

Understanding Preferred Equity

If a company has to suspend its dividend for whatever reason, preferred shareholders have priority when it comes to receiving payment in arrears before the dividend can be resumed for common shareholders. These shares are known as cumulative shares, and if a company has several simultaneous problems concerning preferred shares, they may rank them in terms of priority. The highest-ranking is known as prior and is followed by first preference, second preference, and so on.

If a company is liquidated, preferred shareholders have a prior claim on its assets. Preferred shares are regulated as equity, but in many ways, they’re hybrid assets that lie between bonds and stocks. Since preferred shareholders don’t enjoy the same guarantees as debt investors and creditors, the ratings in these shares are typically lower than the company’s bonds, with accordingly higher yields.

Preferred shares typically don’t carry any voting rights and have less potential to appreciate in price (compared to common stock). They generally trade within a few dollars of their issue price. Premium or a discount trading depends on the specifics of the issue and the company’s credit-worthiness. 

Callable preferred equity shares can be purchased back by the issuer at par value after a set hold period. If interest rates fall and the dividend yields are not high enough to be attractive, the company may call shares. Then, it can issue another series of shares with a lower yield. Certain preferred equity is convertible, which means that it can be exchanged for a given number of common shares. Circumstances include investors given options to convert, Board of Directors voting to convert, or the stocks with pre-set conversion date. Whether this will be an advantage or disadvantage to the investor depends on the price of the common stock.

Conclusion

Business owners that take on outside investors typically have (at least) two classes of securities – common equity and preferred equity. Common equity is equity owned by the business founders, while the preferred equity is the equity owned by investors. Because investors are providing venture capital to the company so it can operate, they get preferential treatment. A preferred equity deal comes with its set of pros and cons for entrepreneurs and crowdfunding investors.

Before deciding to start investing your money on crowdfunding platforms, be sure to understand how they work and whether they will bring you profit. Some crowdfunding investors might be interested in equity options and alternative investments, such as convertible notes, SAFEs (Simple Agreement for Future Equity), or common and preferred shares to gain some passive income and improve their personal finances. Whether you are interested in learning more to make extra money on the side or you wish to become a full time investor as a crowdfunding investor, visit KingsCrowd to learn more.

KingsCrowd is a company and platform involved in the equity crowdfunding market, and we work to give investors access to the best research and analysis. Our experienced team of professionals can educate you about the whole equity crowdfunding ecosystem. We hope to help you understand how it works and make well-informed investment decisions as a crowdfunding investor. For more in-depth information, subscribe today or see our related articles on Is Preferred Equity the ‘Preferred’ Structure of Equity Crowdfunding.”

 


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About: Chris Lustrino

A Boston College Eagle for life, on a mission to democratize startup investing for all people at KingsCrowd, with a passion for Fintech, investing, social impact, doing well and doing good, and an avid runner, cyclist and writer.

View Chris Lustrino's articles

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