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TLDR
- When a startup offers preferred stock, it may consider offering cumulative preferred stock. This type of preferred stock contains a provision that requires that any missed dividend payments be paid out to cumulative preferred shareholders first, before any other shareholders, such as common shareholders.
- Preferred stocks, such as cumulative preferred stocks, often resemble bonds related to valuation. However, preferred stock proceeds have been deemed an asset, whereas bond proceeds are considered a liability.
- Non-cumulative preferred stock, on the other hand, does not pay any missed dividend payments. So, if dividends are not paid or otherwise missed, non-cumulative preferred stockholders miss out on any payments in arrears. In other words, if the startup decides not to pay dividends in any given year, these shareholders forfeit their right to claim any unpaid dividends in the future.
- Cumulative preferred perpetual stock combines the benefits of paying missed dividends while having dividends paid perpetually (as long as the startup remains in business).
You're likely looking for quality investors and investments as a startup founder. To attract the best investors, you need to consider what type of stock ownership you're offering.
Startups typically issue two types of stock – common and preferred. Common stock represents the standard, uniform ownership of a corporation. On the other hand, preferred stock can be more complex.
Preferred shareholders have priority over common stockholders, meaning that they are paid dividends first. However, preferred shareholders do not have voting rights where common shareholders do.
When a startup offers preferred stock, it may consider offering cumulative preferred stock. This type of preferred stock contains a provision that requires that any missed dividend payments be paid out to cumulative preferred shareholders first, before any other shareholders, such as common shareholders.
Let's look more specifically at cumulative preferred stock.
What Is Cumulative Preferred Stock?
As referenced above, cumulative preferred stock is a type of preferred stock. Preferred stocks typically have fixed dividend payments based on the stock's par value. Dividends are paid out regularly, such as quarterly or annually.
Cumulative preferred stock contains a provision requiring that any missed dividend payments be paid out to cumulative preferred shareholders first, before any other shareholders, such as common shareholders.
Preferred stocks, such as cumulative preferred stocks, often resemble bonds related to valuation. However, preferred stock proceeds have been deemed an asset, whereas bond proceeds are considered a liability.
Finally, remember that cumulative preferred stock is preferred stock, not common stock. Therefore, cumulative preferred shareholders don't have voting rights or any other preferences related to corporate governance.
How Does Cumulative Preferred Stock Work?
Let's look at an example of how cumulative preferred stock works.
If a startup runs into financial issues, it may suspend dividend payments to preserve capital. Once these economic issues are resolved, the startup may wish to pay dividends again. If the startup has issued cumulative perpetual preferred stock, then the perpetual preferred stockholders must receive these missed (or suspended) dividend payments first. Other preferred or common shareholders must wait to receive any missed dividend payments or may not be entitled to the missed dividend payments at all, as we discuss further below.
Here's a more specific example illustrating the above:
Suppose a startup issues cumulative preferred stock with a par value of $10,000 and an annual dividend rate of six percent. Thus, the startup should pay cumulative preferred stockholders $600 in dividends annually.
A global pandemic hits the economy, and the economy grinds to a halt. In that case, the startup cannot afford to make its dividend payments. The economy lags for another calendar year, resulting in no dividend payments being made for two years.
The economy rebounds in the following year, and the startup starts paying dividend payments again. However, they owe cumulative preferred stockholders dividends from the previous two years. The startup must pay cumulative preferred stockholders $600 for every two years that dividends were not paid for each share held. Thus, cumulative preferred stockholders are owed $1,200 for each of these shareholders for each cumulative preferred share owned. This must occur first before any other shareholder receives a dividend payment.
Note that you may spread these owed dividend payments out over time. However, if you choose this route, you may not pay dividends to other shareholders until all missed dividend payments are paid.
What Are Some Types of Cumulative Preferred Stock?
Like other types of stock, cumulative preferred stock can fall into different categories. Here are some to consider:
- Value stocks: Value stocks have a low price-to-earnings (PE) ratio, meaning that the stock's price is low relative to its past or projected earnings, potentially being undervalued. Value stocks can be either income or growth stocks. However, many investors prefer value stocks as they hope that the stock's price will bounce back after a market correction. Some examples of value stocks in 2022 include Berkshire Hathaway, Johnson & Johnson, and Procter & Gamble. These stocks are "trading for relatively cheap valuations relative to their earnings and long-term growth potential."
- Income stocks: As an investor, income stocks are the way to go if you prefer consistent dividends. These stocks pay dividends regularly, generating consistent income for the investor. Income stocks are often found in the following industries: real estate, utilities, financial services, and energy.
- Growth stocks: Growth stocks, on the other hand, rarely pay a dividend. This is because these stocks "offer a substantially higher growth rate as opposed to the mean growth prevailing in the market," generating earnings more quickly. Examples of growth stocks have included Meta (formerly Facebook), Netflix, and Amazon.
- Blue-chip stocks: Blue-chip stocks are shares of stock from well-established companies – not startups. These stocks are the most popular stock for investors to buy as they have steady and stable earnings and are typically represented on reputable stock markets, such as the New York Stock Exchange, the S&P 500, or the Nasdaq 100. Some examples of blue-chip stocks include The Coca-Cola Company (NYSE: KO), The Walt Disney Company (NYSE: DIS), and Apple Inc. (NASDAQ: AAPL).
What Is Non-Cumulative Preferred Stock?
Non-cumulative preferred stock, on the other hand, does not pay any missed dividend payments. So, if dividends are not paid or otherwise missed, non-cumulative preferred stockholders miss out on any gains in arrears.
In other words, if the startup decides not to pay dividends in any given year, these shareholders forfeit their right to claim any unpaid dividends in the future.
Cumulative preferred stock is a much more attractive option for investors than non-cumulative preferred stock.
What Is Cumulative Perpetual Preferred Stock?
Now, let's break this down even further. What is cumulative perpetual preferred stock?
Perpetual preferred stock is also a type of preferred stock. It pays a fixed dividend to shareholders for as long as the startup remains in business. The dividend amount is determined on the date that the share is issued. Often, dividends are paid quarterly.
Perpetual preferred stock does not mature on a specific date as non-perpetual preferred stock. In other words, perpetual preferred stock could pay dividends indefinitely (depending on the startup's existence).
However, perpetual preferred stock isn't a permanent decision if the perpetualness of the issue worries you. The startup can still buy back the perpetual shared stock, otherwise called a "call" feature. Founders may wish to buy back the stock because of changes in interest rates or tax laws. However, these buyback features must be described in the stock's prospectus.
Cumulative preferred perpetual stock combines the benefits of paying missed dividends, while having dividends paid perpetually (as long as the startup remains in business).
How Do You Determine a Cumulative Preferred Stock Valuation?
When investors invest in a startup, they want to understand the pricing and valuation of that investment. Additionally, the founder needs to understand these numbers for the capitalization table or cap table, which describes the specific ownership in the company through common or preferred shares and the prices paid by each investor.
It's no different than pricing and valuing cumulative preferred stock.
Calculating the Price of Preferred Stock
First, let's look at how to calculate the cost of preferred stock. Then, we'll look specifically at cumulative preferred stock.
According to Corporate Finance Institute, "[t]he cost of preferred stock to a company is effectively the price it pays in return for the income it gets from issuing and selling the stock. In other words, it's the amount of money the company pays out in a year, divided by the lump sum they got from issuing the stock."
When calculating the cost of preferred stock, founders should use the following formula:
Rp (cost of preferred stock) = D (preferred stock dividend) / P (preferred stock price)
So, let's look at an example using this formula. Suppose a startup offers preferred stock with an annual dividend of $5. If the current stock price is $20, then the cost of the preferred stock is calculated as follows:
Rp = 5 / 20 = 25%
Now, let's look at calculating the cost of preferred stock with a growth rate. In this case, you'll use the following formula:
Rp (cost of preferred stock with growth) = DY1(preferred stock dividend at year 1) / P (preferred stock price) + Growth rate
So, let's look at an example highlighted by the Corporate Finance Institute, with a two percent growth rate and a dividend payment of $3. If the current stock price is $21, then the cost of the preferred stock is calculated as follows:
Rp = 3 / 21 + 2% = 16.57%
As these calculations get more complicated, using a preferred stock calculator would be best.
Now, when determining any cumulative returns (representing as a percentage), use the following formula:
((Current Price of Stock Share) - (Original Price of Stock Share)) / (Original Price of Stock Share)
What Are the Pros of Cumulative Preferred Stock?
When determining what stock to offer for your startup to attract investors, you should consider the pros and cons. Here are the top pros of cumulative preferred stock for investors and startups.
Investors receive dividend payments before common stockholders for holders of cumulative preferred stock.
For startups, the guaranteed cumulative dividend reduces the investment risk for investors. Investors are willing to pay higher costs per share for this reduced risk. Additionally, the guaranteed cumulative dividend provides an additional incentive for giving up voting rights.
What Are the Cons of Cumulative Preferred Stock?
The primary con for holders of cumulative preferred stock is that no voting rights are permitted. As such, these stockholders cannot vote in startup elections.
For startups, paying accrued dividends can reduce cash flow, potentially creating a financial bind.
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If you want to learn more about cumulative preferred stock, we can help you draft the appropriate documents in minutes for your startup. Additionally, we can get your documentation ready, shepherding this process to ensure it's done right. Get in touch to learn more!
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