Preferred Shares and Share Classes

As you pick up shares of stock, one thing you might start to come across are different classes.  Class A, Class B, etc.  You might also see “preferred” shares, which sounds like the status tier of a rental car company.  There are several other permutations within the classes and preferred ranks of stock shares, so let’s talk about what those mean and how they impact you.

Common Stock Share Classes

First, let’s talk about common stock, which is generally more available and is the type that most retail investors purchase when they buy an individual share of stock.  Common stock is differentiated from preferred stock, which I discuss further below.

A company might issue several different “classes” of common stock.  The main differences between share classes are voting rights, entitlement to dividends, and preference for return of capital in the event of liquidation.  Each of these is discussed below.  

Start with voting rights.  Without wading too far into how corporations are structured, suffice it to say that shareholders – depending on the class and type of share held – have the right to vote on major corporate actions.  The most critical of those actions is the election of the company’s board of directors.  A board of directors is a panel of individuals that essentially oversees the highest level functions of a company.  

Every publicly-traded company must have a board of directors.  Among its many responsibilities, the board of directors selects the corporation’s officers, such as the CEO, president, CFO, etc., who run the company on a day to day basis.  You’ll often see that the CEO is the chair of the board of directors, which in turn means that when shareholders vote the CEO off the board, it can translate to the CEO’s removal as an officer. So you see how shareholder voting does have an impact on the company’s operations.

Shareholders vote on other issues too.  They might vote on the board of directors’ salaries.  They might vote on whether the company can issue new shares of stock, or whether the company can go forward with a merger or acquisition.  Every company is slightly different.  When companies form and go public, they must have articles of incorporation that define certain rights of shareholders.  Shareholder voting is how individual shareholders have the opportunity to exercise those rights.

So you see, voting rights for a corporation in which you own shares can have a meaningful impact on how a company does business.  But, different classes may have different voting rights, mostly for the purpose of allowing corporate insiders and original investors to retain greater control despite having issued shares of stock to the general public.  After all, a company’s founders may still want to have significant influence over who sits on the board, and don’t want that influence watered down by giving general stockholders a greater say.  

In addition to voting rights, different share classes may confer different rights to dividends, as well as different rights to receive your investment back if the company is forced to liquidate.  As for the latter, remember that stockholders are the company’s owners, meaning that they essentially have the last claim to any money left if the company has to shut down.  The company’s creditors (including bondholders) get preference to the company’s capital – stockholders generally come last.  But not all stockholders are treated equally – some may have a higher priority when any remaining capital is distributed.  

Below are the most common types of share classes you might see and a general description of the differences between them:

• Class A: these are typically the shares that are issued when the company first starts trading through an IPO.  These generally entitle holders to one vote per share and a standard dividend.

• Class B: these are typically issued to founding members and other early investors in the corporation.  In exchange for the risk they took on, Class B shares often confer more voting rights than Class A shares.  Class B shares may give more votes per share than Class A, in effect giving the Class B holders greater control over corporation decision making.  Class B shares often give a higher preference in the event of liquidation, meaning that if the company goes out of business, Class B shareholders will have their investment returned before Class A shares.

• Class C: these often do not give either any voting rights at all or very limited voting rights.  Several large corporations issue Class C shares so that people can invest in the company without the ability to impact corporate decision-making.

• Class D: these are often mutual fund shares that do not carry load.  Class D shares often carry a per-transaction fee payable to a broker.

• Class I: these shares are institutional shares that are generally only available to high net-worth investors.  Class I shares may carry a minimum investment amount.

These are all very broad descriptions of typical share classes.  A company’s articles of incorporation will detail exactly what classes of shares the company can issue and the differences between them.  And these are not the only classes available – some companies have many more than these while some may only issue one or two classes.  

Preferred Shares

In addition to common shares, some companies may also issue preferred shares.  Preferred shares do actually confer some of the benefits you would expect from the name “preferred,” much like how you can go to the shorter line at the rental car counter.  Typically, preferred shares pay higher dividends or fixed dividends, providing greater certainty about the dividends that the holder might receive.  Dividends are not, however, guaranteed for preferred shareholders, they are merely given a preference when paid out.  The company can still elect not to pay dividends when it lacks the cash to do so or faces other constraints. 

Additionally, preferred shares may also give the holder preference if the company liquidates, meaning that if the company goes under, the preferred shareholders will receive their invested capital before the holders of common shares.  Of course, there’s no guarantee that shareholders will receive their investment back if the company tanks.

The trade-off is that preferred shares do not come with voting rights.  This allows a company to issue “equity” without diluting the voting rights of its common stockholders.  In a way, preferred shares are similar to bonds in that the holders receive regular payments but cannot affect corporate decision-making.  Major ratings agencies rate preferred stock in the same way they do bonds.  Nonetheless, preferred stock still tends to be a riskier investment than a bond because, unlike interest payments, dividends are never really guaranteed.  And even though preferred shareholders are entitled to their capital before common shareholders in the event of liquidation, the preferred shares still come after the bondholders.

Some preferred shares may also be convertible to common shares at a fixed rate, giving holders some flexibility with their investment.  Note also, however, that preferred shares may be “callable” by the issuing corporation, which means that the corporation can choose to repurchase the shares at its election.

For the FIRE Investor

So what does all this mean for a retirement investor?  In short, when you’re purchasing a share of stock, be aware of exactly what you’re purchasing.  This is the same wisdom for any investment you make.

Keep in mind that despite all this, you don’t really have an option with some companies.  There are companies out there that only issue one class of shares to retail traders.  If you purchase a mutual fund or ETF, you may be obtaining a slice of a different class of share, but in that case, your real interest is likely the mutual fund or ETF rather than the classes of its constituent shares. 

But if you do have the option of selecting a share class, remember that it can impact your say in how the company functions.  Now, I’m guessing most long-term investors – particularly FIRE investors who are still working – don’t sit around all day heavily scrutinizing shareholder disclosures so that they can cast an informed vote at every shareholders’ meeting.  You’d be forgiven for not wanting to read the massive packets that you’ll get in the mail or your e-mail every few months.  If you’re well-diversified, the paperwork load can get intense very quickly.

For the most part, companies are still controlled by institutional investors and insiders.  It’s just facts.  But it doesn’t hurt to track your investments in the news.  If you receive notice of an upcoming shareholder meeting, do your research and see what the market is saying about the issues up for voting.  (Like anything on the internet, though, you have to filter what you read and exercise skepticism).  Even with all the information you’ll find, you may find something worthy of your attention that may compel you to cast an informed vote.

Given the option to select a share class to purchase, you’re probably more interested in dividends and liquidation preference.  Remember the pros and cons of dividends.  On the one hand, the more dividends you receive, the more you can reinvest them and grow your holdings.  On the other side of that, the more dividends you receive, the more you pay in taxes.  While you’re in the investing and growth phase of your FIRE pursuit, you have to consider whether it’s better to try to reduce how much you receive in dividends so that you lower your tax burden.  After you retire, you may choose to seek out dividends as a more reliable stream of consistent income.

If you have the option to purchase preferred shares, they can be a means of reducing some risk.  With the more consistent dividend and the higher likelihood of getting your money out if the company liquidates, preferred shares mitigate some of the risk of individual share ownership.  However, preferred shares tend to have less upside potential than common shares – similar to the way that bonds do.  And, when preferred shares are callable, the issuing company can purchase them from you at any time.  The risk of this is that the company can repurchase outstanding preferred shares and then re-issue new preferred stock with a lower dividend, meaning that your “guaranteed” dividend is actually not so.  Think of preferred shares as an option somewhere between a stock and a bond.

Ultimately, it helps to know that there are many variations on the theme of stock ownership.  Next time you look for individual shares of stock, take a look at what you’re actually buying.  What you want to make sure of is that you don’t inadvertently purchase a preferred share when you’re looking for common stock, or vice-versa.  And if you’re the type of person that likes to vote on corporate action, make sure you don’t buy shares without voting rights.  If your interest is dividends, check the historical dividend rate specific to the share class you’re buying – you don’t want to think you’re buying shares that give you a large dividend only to find out that you bought into a different class with different (or no) dividends.

As always, choose wisely and think long-term.  There are options galore out there to invest in, and it’s best to know where you’re putting your money.