Valuation of Preferred Shares
With the help of this article, you will learn the factors on the valuation of preferred shares.
Once your company is up and running, and you are looking to expand and take on new investments, you should consider introducing preferred shares into your company share structure. This is the go to share class for investors looking to invest their funds into a company. But how much do you know about preferred shares and their liquidation rights?
With the help of this article, you will learn the factors on the valuation of preferred shares, and the areas in which investors will look to get advantages of their share holdings. Read on to learn more about the preferred share class.
What are Preferred Shares?
Most companies’ equity consists of either common shares, preferred shares, or both. The reason for these different types are for the different kinds of shareholders of a company, normally common shares for the founders and employees, and preferred shares for investors. In each of these categories, there can also be several classes of common and preferred shares as well. The main difference between these shares are the dividends paid out to preferred shareholders, and also their claim over the payout of the company, after it has settled any debt with its creditors.
You can look at preferred stock as a type of hybrid security; one that has features of both debt (as receiving a fixed income in the form of dividends), and equity (preferential treatment over common shareholders in the case of a company buyout). The preferred shares also benefit from the increase in value of the company with its ownership percentage.
How are Preferred Shares different from Common Shares?
Preferred shares differ from common shares in the features they contain. Whereas common shares are mainly staking claim in the ownership of a company, preferred shares provide incentives for outsiders to invest in the company, including fixed dividends and preferential treatment upon the exit of the company.
Also the type of owners differ for these two types of shares. Common shares are mainly owned by the founders and employees, whereas preferred shares are usually owned by investors in the company. The more benefits a preferred share has, the more attractive it is for people to invest in the company.
With a basic understanding of the reasons for preferred stock, let’s dive into the different features that make up this equity class:
Advantages of Preferred Shares
One of the main benefits of preferred shares are the rights to receive a dividend. These are normally paid out before any other dividends to common shareholders. The dividend rate can be either a fixed number or a percentage of the par value of the shares, or the amount invested by the preferred shareholders. The dividend rate will greatly determine the valuation of preferred shares in the company.
Another feature of these dividends are if they are cumulative or noncumulative. Cumulative preferred shares have a provision that provides all past dividend payments forgone by the preferred shareholders to be paid back before any dividend payments to common shareholders. Noncumulative preferred shares on the other hand do not have this feature, and therefore any missed past dividend payment cannot be reclaimed.
The second feature of preferred shares are its voting rights. Some preferred shares will be either voting or nonvoting shares, affecting their ability to make decisions on behalf of the company. The right to vote in the company decisions will also play a role in how an analyst may view the valuation of preferred shares.
Some preferred shares also include an option to redeem (or call), allowing the issuer to buy back or retire the company shares. This option may be beneficial towards the company if the preferred shares become too expensive, or unfavourable terms exist when the company grows.
On the flip side, there are also preferred shares to sell (or put) these back to the company at a predetermined price at a future date. If this clause exists, then it will affect the valuation of preferred shares in the company.
Participation rights pay a major role during a liquidation event for the company. This feature of preferred shares essentially allow the holder to “double dip” in the total payout of the company based on its equity. The preferred shareholder will first be allowed to receive their initial investment back before the common shareholders, and then receive a percentage of the remaining value based on their shareholdings.
On the other hand, a non participating shareholders would not be paid out before the common shareholders, and would only take home $5 million based on their 50% shareholding. From this example, you can see holding participation rights in a company will also affect the valuation of preferred shares in the case of a company liquidation event.
The last main advantage of preferred shareholders are conversion rights to common shares. These conversion rights allow the investor to convert into a multiple equivalent of common shares, be it 2x, 3x or 4x the number of common shares. This will be advantageous for preferred shareholders in case the value of the common shares increases.
The conversion ratio is normally set when the company issued these preferred shares. The shareholder can then decide if and when they choose to convert these into common shares. For example, let’s take the same company, ABC limited, with a valuation of preferred shares of $100 dollars and conversion ratio of 4. If the shareholder converts these shares, each share would be worth $25 dollars. Now in the case where the common share price exceed $25, it would be beneficial for the shareholder to convert these shares.
However if the preferred shareholder wishes to hold onto their shares until a liquidation event of the company, and these shares have participation rights with no participation cap, then it would be the same to keep these as preferred shares and not convert them. It is because these shares will automatically be calculated as the best case scenario for the preference shareholder upon the exit of the company.
Valuation of Preferred Shares
Like valuing any other financial asset, the valuation of preferred shares is the present value of the expected future cash flows discounted by a rate of return. This rate would be reflective of the risk connected with the preferred shares. If the preferred shares are dividend paying, then an income approach would be applied for discounting the future dividend payments to its present value. For the discount rate, this can either be calculated based on the inherent risk, or obtained from the public market for similar types of financial securities.
In determining the valuation of preferred shares, an analyst would typically perform qualitative analysis to have an understanding of the rights of the preferred shares. The main factors in this analysis would include:
- The financial position of the company in paying the preferred dividends
- The rights and features of the preferreds shares
- The comparability of the preference shares to publicly traded shares
The important steps in determining the preferred share valuation would include:
- Normally the most important factor to consider is the dividend rate and liquidation preferences.
- The valuation of preferred shares is based off this dividend rate and how it compares to that of high-grade publicly traded preferences shares. A lower rate than these publicly traded stock indicates shares worth less than par. If the rate used by the company on other financial instruments, such as on loans to creditors, is higher than this rate, then this should be higher than the publicly traded securities. You should also consider whether the preferred shares have a fixed dividend rate, and if it is a participating shares or not. Both of these will affect the valuation of preferred shares of the company.
You can also try to find a publicly traded company with preferred shares with similar liquidation preferences, voting rights, participation rights and other terms. As very similar shares are often hard to come by, you can try to find the most comparable publicly traded securities to help with the valuation.
- The actual dividend rate would be taken as fact as long as the company has the financial ability to pay off the dividends to the preference shareholders. If the company is not profitable, or is having liquidation issues, then the dividend rate and dividend paying ability may need to be readjusted based on the financial health of the company.
This ability is often defined as coverage. This coverage is measured by the ratio of EBIT (Earnings before interest and tax) over the total interest and dividends to be paid. If the coverage is high, then this indicates a higher probability that the company can cover its interest and debt payments during the year.
- Another factor to consider in the valuation of preferred shares is the ability of the company in paying the liquidation preferences upon exit to the preferred shareholders. This risk is measured by the protection of the company’s net assets, as defined by the excess of the FMV of the company’s assets over its liabilities to the total liquidation preferences. This ratio can also be compared with other publicly traded companies to see whether the company has good protection in covering these liquidation preferences.
- The next factor would be for the existence of voting rights for the preference shares, and how much control it has over the company.
- The last factor to consider is if the preferred shares have any redemption rights. These rights allow the shareholder to redeem their shares at a certain price upon a pre-set condition. The preferred shares valuation would be determined by the ability of the company to pay back these preferred shares.
To summarize these points, it’s important to view the company’s financial condition throughout the year, and its ability to pay off the preferred share dividends and handle liquidation preferences. Conducting a ratio analysis of the company’s financial statements when compared to similar publicly traded company’s preferred shares can be a useful tool.
How to record Preferred Shares on Eqvista
With this information in mind, you can create your own preference share class on the Eqvista App.
Once you have logged into your company profile, go to “Equity share class” under the “Securities” section on the menu bar. From here, you can create a new equity class.
Next select preferred shares as the equity type, and fill in the details of the equity class. On the bottom, you can also choose if the preferred share class has any liquidity preferences upon exit of the shareholder.
You can selection the seniority, participation rights, and dividend details of the share class. These details will stay with all the share grants under this equity class. You can also see how these preferred share advantages affect the payout when you test the waterfall analysis and round modeling of the company.
For more instructions on how to use the Eqvista app, visit our Support page to know more!
With all that we have covered about the valuation of preferred shares, you should now know how each factor plays a role. That is why it’s important for the founders to structure this share class to benefit both the new investors and existing common shareholders of the company.
You can explore different combinations of preferred share rights to attract new investors, and get the necessary funds to help your company grow. The knowledge in this will be crucial for expanding your company in the end.
For this complex preferred share class, its best to store all information on an advanced cap table tool like Eqvista. Our share management tool will help you track all your preference shares, and also automatically calculate how these preferred rights affect the company. This will be especially true in the financial scenarios like waterfall analysis and round modeling, for new investments.