Common vs. Preferred Stock
Voting rights and dividend preferences: who gets what, and when.
Why This Matters
Not all shareholders are created equal.
When you invest in a company, the type of stock you hold determines your rights — and those rights matter enormously when dividends are declared, when the company is sold, and when things go wrong.
Common Stock
Gives you ownership in the traditional sense: a vote, a share of the upside, and a claim on whatever's left after everyone else is paid.Preferred Stock
Gives you priority. Preferred shareholders get paid dividends first, get their money back first in liquidation, but typically give up voting rights and upside.Understanding the difference means understanding how companies structure ownership, who gets paid first, and how those priorities ripple through every dividend declaration.
Common Stock: The Foundation
Common stock is the standard ownership interest in a corporation. When most people talk about "owning stock," they mean common stock.
Rights of Common Stockholders
- 1Voting rights — One vote per share on corporate matters (electing directors).
- 2Dividend rights — Receive dividends when declared (but not guaranteed).
- 3Preemptive rights — Right to purchase new shares before they're offered to the public.
- 4Residual claim — In liquidation, receive whatever is left after all creditors and preferred stockholders are paid.
LIQUIDATION HIERARCHY
Get whatever is left (could be a lot, or nothing)
Common stockholders bear the most risk and receive the most potential reward.
Preferred Stock: Priority with Trade-offs
Preferred stock is a hybrid security — it has characteristics of both debt (fixed dividends, priority) and equity (ownership, no maturity date).
| Feature | Typical Preferred | Common Stock |
|---|---|---|
| Voting rights | Usually NONE | YES (1 vote/share) |
| Dividend priority | FIRST | AFTER preferred |
| Dividend amount | Fixed (stated rate or $) | Variable (board decides) |
| Liquidation priority | BEFORE common | LAST |
| Convertible? | Sometimes (to common) | N/A |
| Callable? | Often (company buys back) | Rarely |
| Participation in growth | Limited | UNLIMITED |
Types of Preferred Stock
Cumulative Preferred Stock
If dividends are skipped in any year, they accumulate and must be paid before common stockholders receive anything. (Most preferred stock is cumulative).
Example: 1,000 shares, $100 par, 6% ($6/share)
Year 1: No dividends paid → Arrears: $6,000
Year 2: No dividends paid → Arrears: $12,000 total
Year 3: Co declares $20,000 total dividend
1. Pay cumulative arrears: $12,000 first
2. Pay current year pref: $6,000 next
3. Common receives: $2,000 (the leftovers)
Note: Dividends in arrears are NOT a liability until declared.
Noncumulative Preferred Stock
Skipped dividends are lost forever — they don't accumulate. Less common, less attractive to investors.
Year 1: No dividends paid → Missed $6,000: GONE
Year 2: No dividends paid → Missed $6,000: GONE
Year 3: Co declares $20,000 total dividend
1. Pay current year pref: $6,000
2. Common receives: $14,000 (No catch-up!)
Participating
After preferred gets its fixed % and common gets a matching %, any excess is shared proportionally between them.
Convertible
Can be converted into common stock at a specified ratio at the holder's option. Lets them participate in massive upside.
Callable
The company can "call" (redeem/buy back) the stock at a specified price after a certain date. Good for company if rates drop.
Issuing Common and Preferred Stock
Issuing Common Stock
ABC issues 10,000 shares of $1 par common at $15/share.
Issuing Preferred Stock
ABC issues 2,000 shares of $100 par, 6% pref. at $104/share.
Note: APIC is tracked separately for common and preferred stock.
Dividend Allocation: Cumulative Walkthrough
This is the most commonly tested scenario in exams. Work through it systematically.
Preferred Setup
500 shares
$100 par
8% cumulative
Common Setup
5,000 shares
$10 par
The Situation
Year 1: $0 declared
Year 2: $0 declared
Year 3: $60,000 declared
Step 1: Calculate annual preferred dividend
500 shares × $100 par × 8% = $4,000 per year
Step 2: Calculate dividends in arrears
Year 1: $4,000 | Year 2: $4,000 → Total arrears = $8,000
Step 3: Allocate Year 3's $60,000
($60k - $8k - $4k = $48k)
The Balance Sheet
Both classes appear in the stockholders' equity section, with preferred listed first (since it has priority in liquidation).
STOCKHOLDERS' EQUITY
Real-World Example
Why companies issue preferred stock instead of bonds.
ABC Coffee Shop wants to expand nationally but doesn't want to dilute current common shareholders' voting power.
Option A: Borrow (Bonds)
- ✗ Adds interest expense
- ✗ Must repay principal
- ✗ Increases debt/leverage ratio
Option B: Preferred Stock
- ✓ No debt (better leverage ratio)
- ✓ No voting dilution
- ✓ No maturity date (don't repay)
- ✓ Fixed dividend attracts income investors
They issue preferred stock to get the capital without the debt burden or giving up control.
Common Mistakes
Mistake 1: Arrears = Liability
Recording skipped cumulative dividends as a liability (Dividends Payable).
No journal entry until declared! Arrears are disclosed in footnotes only.
Mistake 2: Forgetting Arrears Order
Giving preferred only their current year amount, then giving the rest to common.
Work in order: 1) Arrears first, 2) Current preferred next, 3) Common gets whatever is left.
Mistake 3: Voting Rights Assumption
"Preferred stockholders voted for the new board members."
Preferred stock typically has NO voting rights — that's the trade-off for dividend priority.
Key Takeaway
Common stock gives voting rights and residual claim — they benefit most from growth but bear the most risk. Preferred stock gives dividend and liquidation priority, but typically no voting rights and limited upside.
Cumulative preferred means skipped dividends accumulate as arrears and must be paid before common gets anything. Always allocate dividends in order: Arrears → Current Preferred → Common.
Test Your Understanding
See if you've got the basics down. Click each option and check your answer.
Question 1: A company has 1,000 shares of $100 par, 5% cumulative preferred stock outstanding. Dividends were skipped for 2 years. This year, $30,000 is declared. How much do preferred holders receive?
Question 2: Which of the following is typically TRUE for preferred stockholders but NOT common stockholders?
Question 3: Dividends in arrears on cumulative preferred stock are:
Question 4: A company issues 500 shares of $100 par preferred stock at $108 per share. What is the journal entry?
Question 5: True or False: Noncumulative preferred stockholders can receive their missed dividends from prior years before common stockholders are paid.
Ready to Practice?
You now understand both classes of stock. The Practice Lab challenges you to issue stock and work through complex cumulative dividend allocation scenarios.
Try the Practice LabWhat's Next?
Next, we dive into how exactly companies distribute those profits to owners: Dividends.