I Don’t Understand Preferred Dividends… Now What?

One of the most attractive aspects of regular corporations (as opposed to S corps or other entities, like LLCs) is the ability to have multiple classes of stock. The specific benefits of different stock types can attract different kinds of investors. While the exact details of the rights, preferences, and limitations of each kind of stock will be spelled out in your corporate charter or bylaws, there are common benefits for each class. In particular, preferred dividends, a classic benefit of preferred stocks, can be a great option for more risk-averse investors. However, no stock is completely risk-averse—especially when the corporation runs low on funds.

What are preferred dividends?

To understand preferred dividends, it’s important to understand the essential differences between the two basic classes of stock: common and preferred stock.

The benefits of common stock are primarily voice and earning potential. Common stock typically comes with voting rights, meaning shareholders have some say in corporate decisions. Additionally, dividends for common stock are potentially lucrative but can fluctuate widely with the corporation’s earnings and other market factors. Shareholders may not receive dividends at all—corporations aren’t obligated to pay common stock dividends, even if they’re doing well. For instance, they can choose to reinvest profits instead. On the other hand, corporations can also choose to pay out huge dividends if they can afford it. So when it comes to common stock dividends, there’s more risk but also more potential for reward.

Preferred stock typically lacks voting rights—but what this stock lacks in influence, it makes up for in consistency. Instead of fluctuating dividends, shareholders usually receive quarterly or monthly preferred dividends. Preferred dividends are paid at a set rate, called a “coupon rate.” This interest rate is normally a constant, fixed percentage. For instance, if a preferred stock is issued at $25 a share with a coupon rate of 6%, each share would earn $1.50 a year. In other words, preferred dividends can be a fairly predictable stream of steady income for more cautious investors.

The “preferred” part of “preferred stock” also means that these shareholders get priority payments. Preferred stock shareholders receive their dividends before common stock shareholders. This can be particularly important if the corporation is struggling—or worst case, suffers bankruptcy or liquidation. While creditors get top priority in these situations, preferred stock shareholders are next in line for payouts.

What happens if my corporation skips a preferred dividend payment?

Having some issues with earnings and cash flow? You can choose to suspend preferred stock dividends. In other words, you temporarily stop paying out dividends. This is not a step to take lightly. It’s an extreme measure taken in extreme circumstances and requires approval from the board of directors. And the money you save may only be temporary. You will likely have to make up any missed payments to preferred shareholders—but it depends on whether your preferred dividends are cumulative or non-cumulative.

Most guaranteed dividends are cumulative. Cumulative dividends continue to accrue during the period of suspension—meaning they have to be paid in the future. Simply put, when you suspend cumulative preferred dividends, you’re just delaying these payments, not eliminating them. These delayed payments are known as “dividends in arrears” or “accumulated dividends.” And thanks to their “preferred” status, any preferred dividends in arrears must be paid in full before dividends can be paid to common stock shareholders.

On the other hand, if your corporation’s preferred dividends are non-cumulative, then shareholders aren’t entitled to any missed dividends resulting from a suspension.

What happens if my corporation suspends preferred dividends for a long time?

There are perfectly valid reasons to suspend dividends in the short term—for instance, to fund growth or pay for an unexpected expense, such as replacing a major piece of equipment. These situations aren’t likely to cause much shareholder panic.

It’s also possible for corporations to suspend dividends for years at a time. For instance, the toy corporation Mattel Inc suspended dividends after the third quarter of 2017 in response to the bankruptcy of their largest retailer, Toys “R” Us—and the suspension remains today.

However, suspending dividend payments at length does not bode well for your corporation. It’s often a sign of major financial trouble, and this red flag can scare off investors and negatively affect share prices. And while preferred stock shareholders don’t typically have voting rights, don’t forget that if they’re not being paid, then common stock shareholders aren’t being paid either. In extreme cases, unhappy shareholders could take extreme measures—including voting to dissolve or sell the corporation and liquidate its assets.

Shareholders are an essential part of every corporation, and corporations don’t want to disappoint. Sometimes, however, the money just isn’t there or is needed elsewhere. This obviously isn’t ideal, but clear communication goes a long way. In particular, if you can make it clear that a suspension is necessary and temporary, your shareholders still won’t be overjoyed, but they may be patient while your corporation works to bounce back.