Use Of Preferred Stock Research Articles

Liquidation Preference, Participation Rights, and the Cost of Venture Finance

Liquidation preference and participation rights are common features of term sheets involving the use of preferred stock in venture financing. Both these features are typically found in venture financing term sheets and enhance the position of the venture investor compared to company founders. This note illustrates the dramatic effect that these contract terms can have on the cost of venture financing. An illustrative spreadsheet model is available from the author (j_martin@baylor.edu).

Distribution of Stock and Section 306 Stock

The contributed material consists of a chapter on stock dividends and preferred stock bailouts from the Concise Hornbook, Principles of Corporate Taxation (2010). The material explains what is meant by a “stock dividend”and explores the historical tax treatment of those dividends as well as the current treatment. The chapter notes how alternative devices might be used to accomplish consequences that are effectively the same as those that flow from a stock dividend and how the tax laws deal with those equivalent transactions. The several exceptions to exclusion from income are described and illustrated by the use of examples. The rules regarding the determination of the basis of both the old and new stock are examined. The previous use of preferred stock to bail out a corporation’s earnings is demonstrated, and the current rules to prevent the abusive use of so-called “preferred stock bailouts” are examined and illustrated.

How experience and perceptions shape risky behaviour: Evidence from the venture capital industry

This study addresses a hitherto underexplored, but potentially very central issue in venture capital research by investigating whether differences in risk perceptions and professional experience of venture capitalists prompt differing investment and risk reduction strategies. The study is based on a survey sent to 142 Swedish and Finnish venture capitalists, with a response rate of 63% (90 responses). Our results show that experience drives the perception of risk and the riskiness of the preferred investment portfolio. To be more specific, we find that in the presence of more pronounced perceptions of market and agency risk, partly stemming from their experience, investors seem to be willing to take more risks. This result may be attributed to overconfidence, illusion of control, or the speculative dimension of risk present in entrepreneurial settings. The portfolio risk is dynamically attenuated by the execution of various risk reduction strategies, such as syndication, information seeking, monitoring and the use of preferred stock. These findings lead us to believe not only that venture capitalists are proactive and responsible risk takers, who shield themselves from potential losses through a careful application of risk reduction strategies, but also that their responses to risk may resemble more the behaviour of typical entrepreneurs than that of typical managers.

Taxes and the Choice of Issuing Preferred Stock vs. Debt

This study provides descriptive evidence on the link between a firm's expected marginal tax rate and its use of preferred stock as an alternative to financing with long-term debt. Regressions are estimated on a sample of industrial firms that issued preferred stock and a control group, matched on industry and size, that contemporaneously issued long-term debt. Substantial tax effects are found for a full sample of firms that issued any type of preferred stock, as well as a large subsample that issued only convertible preferred stock, frequently used to facilitate mergers and acquisitions. For the typical firm, a decrease in its expected marginal tax rate from the 75th to the 25th percentile is associated with a 33 percent increase in the likelihood it will issue preferred stock. This financing behavior is consistent with a goal of enhancing tax benefits.

Foreign Tax Credit Limitations and Preferred Stock Issuances

This paper documents a consequence of a subset of tax law changes enacted in the Tax Reform Act of 1986 applicable to U.S. multinational corporations. Specifically, we provide evidence that the more stringent interest allocation rules and foreign tax credit limitations enacted in the 1986 Act resulted in the increased use of preferred stock as a financing instrument for U.S. multinationals. By decreasing the tax-favored status of debt for multinationals, Congress provided incentives for issuances of an alternative financing instrument, preferred stock. The cost of capital for multinational firms is a function of their total tax burden consisting of both domestic and foreign taxes. The United States taxes the worldwide income of U.S.-based multinational corporations. In addition, U.S. multinationals pay taxes in foreign jurisdictions based on the tax rules of the foreign governments. The U.S. mitigates, but does not eliminate, multiple taxation of foreign income

ON PREFERRED STOCK

Preferred stock is issued by many corporations in spite of its apparent disadvantages. This study explains why. A simple partial equilibrium model is presented in which preferred shares are both supplied and demanded. Stronger tax incentives in Canada than in the United States may create a positive preferred equilibrium. Empirical evidence on the relative use of preferred stock in the two countries is presented to support this hypothesis.

THE ROLE OF PREFERRED STOCK IN ELECTRIC UTILITY FINANCING*

THIS STUDY UTILIZES the electric utility industry to probe the waning popularity of nonconvertible preferred stock. This industry was selected because it is responsible for one in every three nonconvertible preferred issues marketed over the study period (1950-62). The purpose is to gauge the signs of deemphasis, analyze underlying forces, and evaluate the future role of the security. Data presented and analyzed reflect the declining portion of electric utility capital being raised via preferred stock. Detailed evidence is presented on new issues, refundings, redemption activity, and divestments. On the basis of aggregate data for Classes A and B electric utilities and a study of a core group of 150 companies it was found that a declining trend in preferred stock as a per cent of capitalization exists and is mainly the result of a fall in new offerings. A study of nonconvertible preferred stock contracts (305) indicates a high degree of uniformity which is largely the result of SEC influences under the Holding Company Act of 1935. In general, these issues of preferred stock have cumulative dividend and liquidation preference over common stock and are callable. In the majority of cases contingent voting privileges are given to elect directors upon dividend defaults. Preemptive and participation rights are not present. The low incidence of redemption funds and the frequency of extended retirement periods leads to the conclusion that electric utility straight preferred stocks are generally regarded as permanent capital. A questionnaire-survey of the core group probed a variety of areas, mainly related to forces leading to the lull in preferred stock sales over the past decade. On the basis of the results and extensive examination of the literature, it was concluded that structural shifts in financing are the prime source of deemphasis. The trend of financing reveals a greater reliance upon internally generated funds. The external financing that has been undertaken has been principally in the form of long-term debt. This has been facilitated by somewhat higher debt ratios permitted by regulatory and rating agencies, the cushioning effect of internally generated funds on debt percentages, and the rising levels of federal taxes on corporate income. External equity financing was primarily in the form of common stock. The bullish nature of the market for common stock has permitted many utilities to sell these securities at high price-earnings ratios with little or no dilution. Preferred stock has proven less attractive relative to other means of external financing. A comparison of the assumed role of nonconvertible preferred stock and its role in practice indicates close correlation. In essence the function of the security is to keep debt and equity ratios in line as a compromise vehicle in terms of safety, cost, and flexibility in financing. Moreover, the use of preferred stock carries with it a degree of secondary leverage and when markets are unfavorable for common stock or when dilution of earnings per share is apparent, preferred stock assumes a place in financial planning. An analysis of the practical advantages of substituting