Capital structure decisions are rarely black and white. For companies seeking to optimise their capital stack, a nuanced understanding of the tools available is essential, and among the most critical of these tools are preferred and common stocks. Each comes with its own strategic advantages, costs, and implications for corporate control and risk allocation. For financial professionals and institutional investors, choosing the right mix isn’t just about raising funds—it’s about achieving balance, flexibility, and long-term value.
In this article, we delve into the core structural differences between preferred and common stock, explore their respective roles in the capital stack, and provide insights to guide decision-makers toward optimal capital structuring.
The Capital Stack: A Strategic Balancing Act
A company’s capital stack represents the hierarchy of financing sources, from senior secured debt down to common equity. Every layer of this stack carries varying degrees of risk, return, and influence over corporate governance. Optimising this structure is a central concern for CFOs, treasurers, and investment strategists alike, as it affects everything from cost of capital to shareholder control.
At the bottom of this stack lies common equity, bearing the most risk but offering the highest potential return. Above that sits preferred equity, which acts as a hybrid between debt and equity, providing more predictable returns and priority claims in case of liquidation, but typically without voting power.
Understanding where preferred and common stock fit—and how they interact—is key to maintaining financial resilience and investor confidence.
Preferred Stock: Flexibility with Constraints
Preferred shares are a powerful tool for firms looking to raise equity without diluting voting control or increasing debt obligations. Structured as equity but often behaving like debt, preferred stock usually comes with fixed dividends, giving investors a steady income stream.
Key Characteristics:
- Priority over common stock in dividends and liquidation.
- Fixed or floating dividend payments, often non-cumulative or cumulative.
- Convertible or callable features, depending on terms.
- Generally, no voting rights, preserving management control.
From an issuer’s standpoint, preferred stock can offer flexibility—dividends can sometimes be deferred without default, unlike debt interest. It also appeals to income-focused investors, such as pension funds and insurance firms, seeking less volatile returns than common stock.
However, the cost of preferred equity is usually higher than debt, and in times of strong performance, the fixed dividend can appear burdensome compared to potentially cheaper common equity.
Common Stock: Growth and Governance
Common stock is the foundational equity in any corporation. It represents ownership and carries voting rights, aligning shareholders’ interests with the long-term performance of the business. While it sits at the bottom of the capital stack—meaning it’s last to be repaid in a liquidation—it offers the highest upside potential through capital appreciation.
Key Characteristics:
- Voting rights, including influence over board elections and major decisions.
- Dividends, though not guaranteed, and often variable.
- Residual claim on assets after all liabilities and preferred shares are paid.
- High volatility, reflecting market sentiment and earnings performance.
From a structural standpoint, issuing common stock can be a double-edged sword. While it may not require fixed payments like debt or preferred stock, it dilutes ownership and control. This is particularly sensitive in founder-led or closely held firms that prioritise decision-making autonomy.
Yet, common equity remains essential—not only because of its role in absorbing financial shocks, but also because of its appeal to retail and institutional growth investors.
When to Issue Preferred vs. Common Stock
The decision to issue preferred or common stock is context-dependent and should align with the company’s current needs, future outlook, and investor expectations.
Use Preferred Stock When:
- Seeking non-dilutive capital to protect voting control.
- Funding capital-intensive projects without increasing leverage.
- Appealing to yield-focused investors who favour predictable returns.
- Managing debt covenants, as preferred equity, can be structured to avoid triggering leverage ratios.
Use Common Stock When:
- Scaling up during high-growth phases with long-term capital.
- Building a loyal shareholder base aligned with performance.
- Strengthening governance legitimacy through shareholder representation.
- Supporting M&A activity or stock-based compensation plans.
In some cases, hybrid strategies—such as issuing convertible preferred shares—can offer the best of both worlds, giving investors an income cushion with the option to convert into common equity later.
Investor Implications: Risk, Reward, and Return Profile
From the investor’s perspective, the choice between preferred and common stock reflects risk appetite and return expectations.
- Preferred stock is well-suited to conservative investors seeking fixed income with moderate risk, similar to bonds but with equity upside potential in certain structures.
- Common stock caters to those pursuing capital gains, who are willing to accept greater risk in exchange for voting rights and dividend growth potential.
To view details on how these instruments differ—including pros, cons, and suitability—investors can view this in-depth guide on preferred vs. common stock.
Conclusion
In today’s capital markets, where interest rates, investor sentiment, and competitive pressures shift rapidly, companies must be agile in how they raise and manage capital. By thoughtfully weighing the structural nuances of preferred and common stock, firms can tailor their financing to better support operational goals, shareholder expectations, and long-term growth.
Whether you’re a corporate decision-maker or a professional investor, understanding how each layer of the capital stack functions—and how preferred and common equity serve different purposes within it—is essential to navigating complex financial landscapes with confidence.
