Source: Unsplash
TLDR
- When a startup offers preferred stock, it may issue perpetual or non-perpetual shares. Perpetual preferred stock can exit indefinitely, whereas non-perpetual preferred stock has a specified maturity date.
- 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 perpetual preferred stock is preferred stock that contains a provision that if – for whatever reason – dividend payments were missed in the past, those dividends must be paid to shareholders with cumulative perpetual preferred stock first, before anyone else.
- Non-cumulative perpetual preferred stock, on the other hand, does not pay any missed dividend payments. So, if dividends are not paid or otherwise missed, non-cumulative perpetual 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 perpetual preferred stock is much more attractive to investors than non-cumulative perpetual 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.”
- As we know, perpetual preferred stock recognizes shares in perpetuity, meaning that the dividend payment will stretch out into the future indefinitely as long as the startup stays in business. Therefore, the perpetual preferred stock formula is “the fixed dividend amount divided by the discount rate.”
Startups typically issue two types of stock – common and preferred. Most people are familiar with common stock, representing 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 issue perpetual or non-perpetual shares. Perpetual preferred stock can exit indefinitely, whereas non-perpetual preferred stock has a specified maturity date.
Let’s look more specifically at perpetual preferred stock.
What Is Perpetual Preferred Stock?
As referenced above, perpetual preferred stock is 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.
Finally, remember that because the perpetual preferred stock is a type of preferred stock, not common stock, shareholders don’t have voting rights or any other preferences related to corporate governance.
What Are Some Types of Perpetual Preferred Stock?
Like other types of stock, perpetual 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 Cumulative Perpetual Preferred Stock?
Now, let’s break this down even further. What is cumulative perpetual preferred stock?
Cumulative perpetual preferred stock is preferred stock that contains a provision that if – for whatever reason – dividend payments were missed in the past, those dividends must be paid to shareholders with cumulative perpetual preferred stock first, before anyone else.
Let’s look at an example of when this can happen. 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.
What Is Non-Cumulative Perpetual Preferred Stock?
Non-cumulative perpetual preferred stock, on the other hand, does not pay any missed dividend payments. So, if dividends are not paid or otherwise missed, non-cumulative perpetual 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 perpetual preferred stock is a much more attractive option for investors than non-cumulative perpetual preferred stock.
How Do You Determine a Perpetual 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 perpetual preferred stock.
Calculating the Price of Preferred Stock
First, let’s look at calculating the cost of preferred stock. Then, we’ll look specifically at perpetual 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 calculate 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.
Calculating the Price of Perpetual Preferred Stock
As we know, perpetual preferred stock recognizes shares in perpetuity, meaning that the dividend payment will stretch out into the future indefinitely as long as the startup stays in business.
Therefore, the perpetual preferred stock formula is “the fixed dividend amount divided by the discount rate.” Thus, the formula is expressed as follows:
Perpetual preferred stock price = fixed dividend amount / dividend yield
Here’s an example:
Suppose your startup investor purchases 100 shares of a perpetual preferred stock that pays an annual $4 dividend. The investor bought the stock for $50 a share, so the dividend yield is 8 percent. The present value is $4 divided by 0.08, or $50, precisely the amount you paid.
Pros of Perpetual 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 perpetual preferred stock for investors.
First, holders of perpetual preferred stock received their dividend payments before common stockholders.
Second, holders of perpetual preferred stock have priority over common stockholders if the startup files for bankruptcy and the startup’s assets are liquidated.
What Are the Cons of Perpetual Preferred Stock?
The primary con for holders of perpetual preferred stock is that no voting rights are permitted. As such, these stockholders cannot vote in startup elections.
We can help!
At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most—your business.
If you want to learn more about perpetual 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!
Like our content?
Subscribe to our blog to stay updated on new posts. Our blog covers advice, inspiration, and practical guides for early-stage founders to navigate their startup journeys.
Note: Our content is for general information purposes only. AbstractOps does not provide legal, accounting, or certified expert advice. Consult a lawyer, CPA, or other professional for such services.