Common vs. Preferred: Does it matter in a business sale?

|Acquisition Q&A

You receive an offer for your business that contemplates you rolling over equity into NewCo. It outlines common stock for you and preferred stock for the investor. What does this mean and why is it important to you?

Broadly, equity falls into two classes: Common or Preferred.

You’re likely familiar with common equity, which is the amount that all common shareholders have invested in a company and includes common stock, additional paid-in-capital and retained earnings. Common stock is typically held by founders, or employees/shareholders who buy-in, and comes with the right to vote on certain company matters. In addition, common stock shareholders often enjoy “preemptive rights” allowing them to maintain proportional ownership even if more company stock is issued. Given all of these privileges, it may seem that common stock is the best way to invest. The drawback to common stock, however, is that its shareholders are the last in line to receive the company’s assets: they get dividend payments only after all preferred shareholders receive their dividend in full, and they are the last to be repaid in the case of bankruptcy, behind creditors and preferred shareholders.

So, what about preferred equity? Is it really… preferable?

Preferred equity (also known as preferred stock) is a hybrid class of equity that combines features of common equity and debt. Like debt, preferred equity earns a rate of return known as the coupon. This coupon is typically a fixed dividend, but can also float with a market index such as LIBOR. Because preferred equity is not secured by collateral, it receives a higher rate than secured debt. The dividend may be in cash or payment-in-kind (PIK). PIK grants the holder of the preferred equity additional shares of preferred equity instead of cash, increasing his or her total stake. It’s also important to note that, like debt but unlike common stock, preferred equity ownership may or may not come with voting rights, limiting the holder’s control of company decisions.

Moreover, preferred equity can have warrants attached. These warrants provide the holder the right to convert the preferred equity to common equity. Unlike creditors, preferred equity holders are able to use this feature to participate in the upside of the business if the value of the common equity increases.

In the instance of a liquidating event like a second sale or bankruptcy, all creditors (senior and subordinated) are paid first, then preferred equity holders get paid, and finally common equity holders split what is remaining. This means if your roll-over is solely in common stock and your investment partner is in preferred equity, they get the benefit of their full return before you get any benefit.

So… how should you structure your transaction?

Going through a recapitalization, it’s important to consider structure and push for ownership that is pari passu to your new capital partner. This means, you are treated the same and if they are holding preferred equity and common, you are as well. That way, when the proceeds are distributed, you get the same level of pro-rata proceeds as your partner.

To better understand how capital structure decisions can affect your transaction, we’d love to hop on a call and discuss further.

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